coal-processing factory

King Coal has lost its crown. Since prices spiked in the wake of the Australian floods of 2010 it has been all one way for thermal coal – down.

But a rally in several coal benchmarks has brought the market back to life and raised hopes the fossil fuel, which is used to generate electricity around the world, might have bottomed. The Australian spot price has risen almost 9 per cent since its August low to $82.80 a tonne, while its South African equivalent is nearly 17 per cent higher at $83.39.

Rising thermal coal prices makes a big difference to the profitability of several large producers, including miners Glencore Xstrata, Rio Tinto and Anglo American. They are also important for large traders of thermal coal such as Vitol and Noble.

Yet the outlook for thermal coal remains poor. Supply continues to expand, with producers in Australia and Indonesia, the world’s biggest exporter, still to curtail output in the face of weaker prices. Merrill Lynch estimates a fifth of seaborne thermal coal producers are not covering their cash costs at current prices.

“There’s good demand everywhere – but there is just too much supply,” says one industry executive.

While an unusually cold winter in the northern hemisphere and further disruptions in Colombia, which exports almost 70 per cent of coal to Europe, could help support thermal coal, most analysts expect prices to come under pressure in 2014, especially if demand from China weakens.

“On balance the global coal market looks oversupplied in 2014, creating the scope for further price weakness,” analysts at Merrill Lynch wrote earlier this week.

Given that backdrop, there was surprise when prices jumped suddenly in October. However, many market participants are sceptical the spikes signal better times ahead. Instead, they pin the recent moves on an aggressive trading strategy.

The locus of the move, according to some analysts, was coal exported from South Africa into Europe. An index which tracks Richards Bay coal has risen as much as 25 per cent since August and has pulled several other benchmarks with it.

But, far from signalling a change in sentiment, traders reckon the move was caused by supply disruptions in Russia and Colombia, and may have been exacerbated by trading house Vitol. The commodities trading house bought large quantities of Richards Bay coal for sale into Europe, several market participants have told the Financial Times.

Some claim Vitol also has a much larger derivatives position, betting that implied freight – or the price differential between API4, the benchmark South African swaps contract, and API2, the equivalent for coal imported into northwest Europe – would shrink.

“You had a trader with a ‘short’ implied freight position. Effectively, they were bidding up cargoes in order to support that position,” suggests Ivan Szpakowski, commodities strategist at Citi, who declined to name the trader.

Coal delivered to the European hub of Rotterdam has traditionally fetched a premium to Richards Bay to reflect the costs of the 8,200-nautical mile voyage. But for long periods since August the roles have been reversed and Richards Bay has traded at a premium.

At least one large thermal coal trader has complained to financial regulators in the UK and Switzerland, where Vitol is headquartered, about the price movements, according to people familiar with the matter.

Vitol said that price movements in API4/API2 in the last six months had not been unusual. It added that comments on its trading positions were based on speculative and incorrect assumptions. “Vitol takes its regulatory responsibilities, including those in respect of market behaviour, extremely seriously. Any suggestions to the contrary will be strongly contested,” it said.

According to a recent note from Citi, the ability of any trader to execute such a large move would illustrate an important market trend. While inventories at Richards Bay and rail deliveries are at record levels, an increasing amount of coal produced is not at the 6,000 kilocalorie benchmark upon which futures are traded.

“Similar to iron ore, this decreasing availability of index grade material is making these indices less representative of the market as a whole and more vulnerable to influence from factors specific to benchmark grade material: for example, a production disruption, hoarding of cargoes,” Citi said in the note, adding that these influences were temporary and should soon pass.

If and when they do, thermal coal’s weak fundamentals will come back into view. Australia and Indonesia, the world’s two largest exporters are continuing to increase supply, while demand growth from China, which has soaked up excess seaborne supply in recent years, could be affected by new environmental regulations.

Macquarie estimates seaborne thermal coal exports from Australia and Indonesia are up 14.2m and 36.5m tonnes respectively in the year to date. There are also question marks about India’s appetite for thermal coal imports following the depreciation of its currency this year.

Indeed, prices have already pulled back from their recent highs. Richards Bay spot has fallen almost 4 per cent over the past month. And prices may have to fall further before King Coal can rise again.

“The solution to the oversupplied market is to inflict further pain on producers via lower prices, forcing them to curtail output,” Merrill said in its report.

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