The coal market has seen a surge in demand driven largely by China. Now price levels appear to have peaked and coal faces the challenge of competing under the low carbon agenda.

Bevan Jones, Global Coal Limited

Although coal is one of the oldest energy fuels, the global coal market has only recently evolved along lines similar to the oil market. Global coal production has grown slowly but surely over the last decade with upwards of some five billion metric tonnes (t) produced each year. The international steam coal seaborne traded market has developed a number of coal price indices which are widely used in offsetting price and volume risk in financially settled markets. As with oil, these financial markets offer advanced risk management tools such as swaps and options and such markets tend to grow far larger than their physical counterparts in gross volume terms.

Demand slowing

International demand growth throughout the remainder of 2005 and into 2006 is expected to be around 2-4 per cent, approximately half that experienced in 2004. Sometime during 2006, it is expected that demand for international traded seaborne coal should pass 500 million t. For comparison’s sake, the nascent financial coal market is currently trading around 600 million t per annum.

The coal market entered a new phase midway through 2004 as surging Asian demand pushed coal prices to record inflation-adjusted highs. In Asia, and especially China, local production could not keep pace with this demand feeding the Chinese growth engine. The Chinese effect has now become the most talked about and most uncertain feature of the global coal market. Indonesian production is ramping up as new mines are put into operation, which has become of importance in Asia as well. As Chinese suppliers export less, the world struggles to meet the gap in supply even with the incremental supply from Indonesia.

Figure 1. Approximate percentage breakdown for segments of the coal market
Click here to enlarge image

Regionally, Europe imports a little more than 40 per cent of world steam coal, following behind Asia with about 48 per cent. European coal demand continues to subside with increasing competition from other fuels and the impact of the EU Emissions Trading Scheme (ETS) which went live at the start of 2005. Europe is also becoming increasingly dependent on international supplies as domestic production grinds to a halt. However, Polish lignite remains a feature of large parts of European baseload supply.

Asia is expected to remain the key growth driver in 2006 with new power station builds in Korea and Malaysia coming online. The return of nuclear power capacity in Japan has, however, capped the Japanese appetite for coal. Both China and India will continue to look for more stable international supplies which should underpin demand although European demand will continue to fall. More reliable hydropower and a much stronger political commitment to gas are also influencing European demand. Some opportunity exists for further international demand growth in the US as well as Brazil and Mexico but this is likely to be small in comparison to Asia.

Bonanza over

The mining supply cycle tends to go through consecutive stages of boom and bust. The consolidation in the industry following the last bust when players such as BP, Exxon and Shell exited the coal market has left supply in the hands of a few large majors with a long tail of smaller independent national suppliers. There is no doubt that the recent consolidation in coal market supply helped the coal price reach record highs in 2004 but there are signs that the bonanza is over.

Figure 2. Gross profit margins of some major coal suppliers
Click here to enlarge image

Global coal supply has now generally caught up with, and in some cases is now exceeding, demand on a regional basis. The market is forecasting increases in supply coming from “cleaner” Indonesian, Columbian and Russian coals. With falling demand and supply changes in the Atlantic and Pacific, this most likely means that supplier positions in South Africa and Australia will be constantly changing in the future. Even with coal supply responses to market price, the remainder of 2005 could see some distinct imbalances in both the Atlantic and Pacific until the situation is more stable in 2006. Matching regional supply and demand is always a difficult task as the marginal tonne is affected by the prevailing freight market. Most Asian buyers prefer to purchase direct from suppliers and hence keep Pacific freights a fuzzy guess at best. On the Atlantic side, the freight market is keenly and transparently traded into Amsterdam, Rotterdam and Antwerp (ARA). Nevertheless, freight rates across the board have been plummeting from their recent highs of late and this will play a large role in determining supply-switching abilities for producers.

Manageable volatility

Taking into account these factors, the international coal price will continue to be volatile over the next few years. The market will remain above its long term average until either production unexpectedly ramps or economies like China start to slow down. Although both coal and freight continue to experience more volatility than ever before, volatility now appears to be bound in a manageable price-risk range with a slightly bearish trend to it.

The liberalization of European power markets has increased the importance of cost reduction in power generation. The coal price is a major risk factor for most European coal consumers as not only do fuel costs make up a large part of total costs, the spot coal price is also the most uncertain of all cost components. Most European coal consumers are familiar with the “dark spread”, being the $/MWh margin between spot power prices and the equivalent per MWh cost of coal. The dark spread will most likely remain more profitable than the spark spread (being the profit margin for gas) for some time.

Low carbon agenda

European consumers now have to contend with the EU ETS which requires generators to purchase enough allowances to cover their expected CO2e burn. Although governments were rather generous to generators in granting initial allowances in their national allocation plans, many generators appear to be erring on the safe side and are accumulating, rather than selling/trading their allowances. This provides coal purchasers with a window of comfort through 2005 and no significant direct pressure appears to have been placed on the international coal price as a result of carbon allowance trading as yet. Through Kyoto structures such as the Clean Development Mechanism (CDM) and Joint Implementation (JI), coal producers in countries that qualify for CDM such as Indonesia and South Africa can partner with local renewable energy suppliers in order to earn carbon credits. These credits can be “packaged” with coal in order to lower the effective cost to their European clients.

As the EU ETS starts to affect coal pricing it is expected that coals with lower carbon content will find more favour amongst consumers than high carbon coals. The corresponding degradation in heat content is of course a mitigating factor. From 2008 other pollutants such as SOx and NOx will start to play a role exerting further pressure on coal purchase patterns. In the meantime, 1 t of a relatively low carbon coal from Russia would produce around 2.3 t of CO2e and would incur a cost of around $55/t at current permit prices of some $24.45/t. A relatively high carbon coal from Australia would similarly incur a cost of around $71/t. However, forward power prices remain high and all coal sources bought into Europe are currently profitable in such an analysis. Windfall profits are available to generators that displace their coal purchases with cleaner fuels and sell excess allowances on the open market.

Lower political risk

Ultimately it is not clear which direction the global coal market is heading. Most players are expecting a slightly less volatile period ahead after the recent turbulence. Coal reserves remain far larger than for oil and gas. In addition, coal is produced in regions with generally lower perceived political risks. It remains well positioned in terms of global supply security in that if coal production in one country falls short, exports from other countries could easily be redirected. Although much plant capacity currently needs to be rebuilt and/or renewed, the European power mix will remain a battleground between coal, gas and nuclear with change most likely taking place fairly slowly.

The European ETS will no doubt have a bearish effect on coal prices, especially as the other greenhouse gases are added to the mix from 2008. However, the short-term affect remains to be seen. Asian countries have and will continue to look at emission-reated taxes although these will likely remain fairly insignificant in the foreseeable future. In the long term, steam coal’s future will increasingly depend on improved “clean coal” technologies with higher plant efficiencies and lower environmental impacts.