Coal on the rocks

The over-the-counter coal market has suffered a steep drop in trading volumes as the energy merchant firms that drove the market cut back their trading operations. The size of the market is hard to gauge, but brokers we contacted put it at 100–200 million tonnes a year, a significant decrease in volumes from 12–24 months ago.

Tom Hiemstra, vice-president of coal services at broker Evolution Markets in New York, says that a year ago only about 10–15% of coal traded on the OTC market – which he estimates was 400 million tonnes a year – was directly destined for physical delivery. The rest was traded several times between companies before delivery. “But this is drying up: the market’s now almost 100% coal for physical delivery,” he says.

The US consumes about 1 billion tonnes of coal every year, according to the Energy Information Administration, the statistical arm of the US Department of Energy.

Hiemstra says the changes in the coal market mirror those in the electricity trading sector. “There are fewer players and has been an almost total drop in speculative trading without physical assets,” he says. “Traders are now approaching the market from an asset-optimisation standpoint.”

Coal-electricity link
The catalyst for OTC coal trading was the deregulation of the electricity sector in the 1990s in the US and Europe. Coal production and electricity generation are closely linked: in the US, coal-fired plants generate over half the nation’s electricity, and more than 90% of domestic coal is sold to power-generating companies, according to government figures. The situation is similar in Europe, with almost 50% of German and 35% of UK electricity generated from coal.

As electricity firms entered the spot market in order to better manage their price risk, the demand for coal contracts that had predominantly been signed for long periods – sometimes up to 20 years – was replaced by a growing short-term market. And while long-established coal companies retained the lion’s share of production, it was the demand from liberalised energy firms that drove the trading market.

So, as energy merchant companies have cut their trading operations, coal trading has also suffered. Stephen Doyle, president of New York-based Doyle Trading Consultants, says: “Comparing the first quarter of 2003 to the first quarter of 2002 is almost like comparing day and night. We’ve lost so many big players: Dynegy, El Paso, Mirant, TXU, Allegheny, Aquila and Duke have all pulled out of the market.”

Companies that Doyle says are still active in the market on a regular basis include American Electric Power, Ameren Energy, Constellation Energy, DTE Energy and SSM Coal, a subsidiary of German firm RWE Trading.

But the loss of leading energy merchants has hit liquidity in both standard OTC contracts and structured products. The most liquid US OTC products are the New York Mercantile Exchange (Nymex) look-alike contracts, the Pacific River Basin 8400 and 8800 British thermal unit contracts – and the CSX contract.

Structured products – such as tolling agreements, under which one company sells fuel to another and receives the proceeds from sales of the electricity output – are traded on a one-off basis. Doyle says the amount of trading in all such products has declined.

So what needs to change for the OTC market to reach the levels seen one or two years ago? Hiemstra says: “We need new entrants. At Evolution, we’ve seen a growing level of interest from the financial sector, but the banks aren’t trading yet. If they did enter, that would establish credit quality again.” Banks, with their solid investment-grade credit ratings, would help compensate for the collapse in credit quality among energy merchant firms over the past year, he says.

But the issue of poor credit quality is not just confined to the high-profile energy companies. “There was a period when very few producers were making any money, which meant they had a lot of debt,” says Hiemstra. “From a rating standpoint, the producing companies weren’t on a par with the energy merchants a couple of years ago.

“These energy merchants were playing the counterparty role by allowing companies to hedge trades,” he adds. “Since credit quality in the energy trading sector as a whole is down, this outlet for hedging has been lost.”

DTC’s Doyle says some investment banks have contacted him expressing an interest in the coal trading sector, but as yet none have started trading. “What banks want to see before they enter the sector is an active swap market, and that’s a long way off,” he says.

Accurate information
Doyle says two important factors need to be in place before a swap market can function: an underlying OTC market more liquid than the current one, and one or more price indexes that give an accurate reflection of price information.

The accuracy of price indexes – and particularly their vulnerability to manipulation by traders – has become an important issue in the natural gas market in the past six months, following revelations of false reporting by some traders at major energy companies (see EPRM January 2003, page 16). But Doyle says indexes used in the coal trading sector are even more vulnerable to manipulation.

“Right now, it’s a big question whether to use a published index – such as the one produced by [data provider] Platt’s – or to use an independent third party that polls and audits results,” he says. The most-used index is the All Price Index (API ), which is based on prices from a number of publications including Platt’s Coal Daily and the McCloskey Coal Information Services (MCIS) steam coal marker price.

“This was a big challenge for the coal trading industry, even before events [involving false reporting] in the natural gas market last summer brought the index issue to wider attention,” says Doyle. “In the natural gas market, people hoped the sheer volume of companies and trades would negate the effects of any misreporting. But in the coal sector, the volumes are so much lower that even that safety net wasn’t available.”

One company aiming to change the system is London-based globalCOAL, which operates an electronic market for coal trading. GlobalCOAL currently publishes indexes for two main coal trading hubs, which include Richards Bay, South Africa (the RB Index) and Newcastle, Australia (the Newc Index). And globalCOAL is in the process of developing an index for the Amsterdam-Rotterdam-Antwerp (ARA) trading hub.

GlobalCOAL’s indexes are based on published methodologies, which take into account both bids and offers submitted to and trades executed on the firm’s platform. All physical trades executed on the platform are governed on the basis of globalCOAL’s Standard Coal Trading Agreement.

Patrick Markey, director of marketing at globalCOAL, says users can trade financial swaps based on the company’s indexes. In addition, he says the international seaborne swaps market for steam coal is estimated at 400+ million tonnes a year.

Futures
Another key indicator of a healthy trading market is a futures contract, and there has been a lack of significant activity on the Nymex coal futures contract since its launch in July 2001. Figures from Coal Daily show only a handful of reported trades in late 2002 and early 2003.

DTC’s Doyle says a combination of bad timing and the collapse in trading volumes have damaged the contract’s chances of success. In the first six months after the launch, the terrorist attacks of September 11 disrupted trading activity on the exchange and Enron’s bankruptcy started the slide in trading volumes across the energy markets.

One occasional user of the coal futures contract says Nymex is in the process of transferring the contract from floor trading to the exchange’s electronic system, Access. “Once that happens, there’s no real possibility of it being brought back onto the floor, and it’s likely to die a slow death,” he says. “It’s a sad end to what was once a promising product.”

Instead, participants are seeking to boost liquidity in the OTC market – and if that happens, an exchange-traded contract may become a reality.