Hedging Against Rising Coal Prices using Coal Futures

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Contents

Hedging Against Rising Coal Prices using Coal Futures

Businesses that need to buy significant quantities of coal can hedge against rising coal price by taking up a position in the coal futures market.

These companies can employ what is known as a long hedge to secure a purchase price for a supply of coal that they will require sometime in the future.

To implement the long hedge, enough coal futures are to be purchased to cover the quantity of coal required by the business operator.

Coal Futures Long Hedge Example

A power company will need to procure 155,000 tons of coal in 3 months’ time. The prevailing spot price for coal is USD 74.45/ton while the price of coal futures for delivery in 3 months’ time is USD 74.00/ton. To hedge against a rise in coal price, the power company decided to lock in a future purchase price of USD 74.00/ton by taking a long position in an appropriate number of NYMEX Coal futures contracts. With each NYMEX Coal futures contract covering 1550 tons of coal, the power company will be required to go long 100 futures contracts to implement the hedge.

The effect of putting in place the hedge should guarantee that the power company will be able to purchase the 155,000 tons of coal at USD 74.00/ton for a total amount of USD 11,470,000. Let’s see how this is achieved by looking at scenarios in which the price of coal makes a significant move either upwards or downwards by delivery date.

Scenario #1: Coal Spot Price Rose by 10% to USD 81.90/ton on Delivery Date

With the increase in coal price to USD 81.90/ton, the power company will now have to pay USD 12,693,725 for the 155,000 tons of coal. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the coal futures price will have converged with the coal spot price and will be equal to USD 81.90/ton. As the long futures position was entered at a lower price of USD 74.00/ton, it will have gained USD 81.90 – USD 74.00 = USD 7.8950 per ton. With 100 contracts covering a total of 155,000 tons of coal, the total gain from the long futures position is USD 1,223,725.

In the end, the higher purchase price is offset by the gain in the coal futures market, resulting in a net payment amount of USD 12,693,725 – USD 1,223,725 = USD 11,470,000. This amount is equivalent to the amount payable when buying the 155,000 tons of coal at USD 74.00/ton.

Scenario #2: Coal Spot Price Fell by 10% to USD 67.01/ton on Delivery Date

With the spot price having fallen to USD 67.01/ton, the power company will only need to pay USD 10,385,775 for the coal. However, the loss in the futures market will offset any savings made.

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Again, by delivery date, the coal futures price will have converged with the coal spot price and will be equal to USD 67.01/ton. As the long futures position was entered at USD 74.00/ton, it will have lost USD 74.00 – USD 67.01 = USD 6.9950 per ton. With 100 contracts covering a total of 155,000 tons, the total loss from the long futures position is USD 1,084,225

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the coal futures market and the net amount payable will be USD 10,385,775 + USD 1,084,225 = USD 11,470,000. Once again, this amount is equivalent to buying 155,000 tons of coal at USD 74.00/ton.

Risk/Reward Tradeoff

As you can see from the above examples, the downside of the long hedge is that the coal buyer would have been better off without the hedge if the price of the commodity fell.

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Hedging Against Falling Coal Prices using Coal Futures

Coal producers can hedge against falling coal price by taking up a position in the coal futures market.

Coal producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of coal that is only ready for sale sometime in the future.

To implement the short hedge, coal producers sell (short) enough coal futures contracts in the futures market to cover the quantity of coal to be produced.

Coal Futures Short Hedge Example

A coal mining firm has just entered into a contract to sell 155,000 tons of coal, to be delivered in 3 months’ time. The sale price is agreed by both parties to be based on the market price of coal on the day of delivery. At the time of signing the agreement, spot price for coal is USD 74.45/ton while the price of coal futures for delivery in 3 months’ time is USD 74.00/ton.

To lock in the selling price at USD 74.00/ton, the coal mining firm can enter a short position in an appropriate number of NYMEX Coal futures contracts. With each NYMEX Coal futures contract covering 1,550 tons of coal, the coal mining firm will be required to short 100 futures contracts.

The effect of putting in place the hedge should guarantee that the coal mining firm will be able to sell the 155,000 tons of coal at USD 74.00/ton for a total amount of USD 11,470,000. Let’s see how this is achieved by looking at scenarios in which the price of coal makes a significant move either upwards or downwards by delivery date.

Scenario #1: Coal Spot Price Fell by 10% to USD 67.01/ton on Delivery Date

As per the sales contract, the coal mining firm will have to sell the coal at only USD 67.01/ton, resulting in a net sales proceeds of USD 10,385,775.

By delivery date, the coal futures price will have converged with the coal spot price and will be equal to USD 67.01/ton. As the short futures position was entered at USD 74.00/ton, it will have gained USD 74.00 – USD 67.01 = USD 6.9950 per ton. With 100 contracts covering a total of 155000 tons, the total gain from the short futures position is USD 1,084,225

Together, the gain in the coal futures market and the amount realised from the sales contract will total USD 1,084,225 + USD 10,385,775 = USD 11,470,000. This amount is equivalent to selling 155,000 tons of coal at USD 74.00/ton.

Scenario #2: Coal Spot Price Rose by 10% to USD 81.90/ton on Delivery Date

With the increase in coal price to USD 81.90/ton, the coal producer will be able to sell the 155,000 tons of coal for a higher net sales proceeds of USD 12,693,725.

However, as the short futures position was entered at a lower price of USD 74.00/ton, it will have lost USD 81.90 – USD 74.00 = USD 7.8950 per ton. With 100 contracts covering a total of 155,000 tons of coal, the total loss from the short futures position is USD 1,223,725.

In the end, the higher sales proceeds is offset by the loss in the coal futures market, resulting in a net proceeds of USD 12,693,725 – USD 1,223,725 = USD 11,470,000. Again, this is the same amount that would be received by selling 155,000 tons of coal at USD 74.00/ton.

Risk/Reward Tradeoff

As can be seen from the above examples, the downside of the short hedge is that the coal seller would have been better off without the hedge if the price of the commodity went up.

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Investing in Growth Stocks using LEAPS® options

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Bull Call Spread: An Alternative to the Covered Call

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Dividend Capture using Covered Calls

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Leverage using Calls, Not Margin Calls

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Understanding the Greeks

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No future(s): Asian financial coal trading dries up as Noble declines, Glencore rules

SINGAPORE/FRANKFURT (Reuters) – Financial trading of thermal coal has virtually ceased in Asia as a result of the woes at one major trading house and the growing dominance of another, despite the region being by far the world’s biggest consumer of the fuel.

Asia gobbles up some 70 percent of all coal used for power generation, and the unprecedented demise of its futures market poses significant risks for utilities in particular.

With coal prices rising sharply this year, power generators would usually hedge or protect themselves by taking positions in related derivatives markets.

“With Asia’s futures pretty much gone, that greatly increases our risk for supplies in that region. It may mean that we source less from there going forward,” said a risk manager with a big European utility, declining to be named as he was not authorized to speak publicly about company risk.

Data from several exchanges shows that since its heyday in 2020, Asia coal futures trading activity has declined by over 90 percent.

Two senior coal brokers and six senior traders at merchant houses, utilities and miners spoken to by Reuters pointed to the shrinking role of Singapore-listed commodity merchant Noble Group ( NOBG.SI ) as the single most important factor in the decline of Asian coal futures volumes.

Noble has sold-off assets and slashed trading operations following allegations from Iceberg Research in 2020 that it had overstated its assets by billions of dollars, sending its share price tumbling.

“Noble is a massive loss to the market. Its troubles seriously dented liquidity,” one merchant trader said.

Noble declined to comment for this article, but said in a letter to Singapore Exchange in May “very thin trading liquidity” in hedging instruments had contributed to its first quarter losses.

GLENCORE DOMINANCE

Many traders also see a link between declining Asian coal futures and the growing dominance of a single company in supplying physical Asian coal.

Swiss-based, London-listed Glencore ( GLEN.L ) is the world’s biggest producer of thermal coal, exporting well over 50 million tonnes from Australia alone in 2020, a quarter of the country’s shipments. Physical Newcastle coal prices, which act as Asia’s key futures benchmark, have jumped from around $70 to over $100 per tonne this year.

Glencore, which owns a dozen thermal coal mines in Australia, declined to comment. But market participants say the firm is not as active in coal futures trading as many of its peers, instead preferring bilateral supply deals with customers.

“Doubts over deliberate intervention on the supply side for Australian coal linger, which kills any enthusiasm to trade the (financial) product,” said Georgi Slavov, head of research at commodity brokerage Marex Spectron.

Glencore’s control and knowledge of actual coal output in Australia and the influence this has on derivatives contracts means it is difficult for outsiders to predict price movements, scaring off traders.

“If you don’t know what Glencore’s mines are up to, it’s very hard to trade Australian coal futures,” said one trader with a large European utility. “It’s not Glencore’s wrongdoing, just the way it is.”

Glencore has previously said it is as vulnerable as any other market participant to commodity price swings, and in the past has also used derivatives to hedge its own production.

STEEP DECLINE

The decline in Asian coal futures volumes stands in stark contrast to booming oil and natural gas futures.

The amount traded in front-month Australian coal futures on the Intercontinental Exchange ( ICE.N ) has collapsed from a high of over 1.6 million tonnes in September 2020 to under 290,000 tonnes this September.

Data from rival CME Group ( CME.O ) shows that open interest, which describes the number of open positions, of its Asian coal futures as fallen from around 2.7 million tonnes in early 2020 to just 65,000 in August this year, with Indonesian and Chinese futures totally vanishing.

“In that sort of environment, utilities stop hedging. It’s too risky,” said a senior coal trader with a major commodity merchant, requesting anonymity.

Major European utilities that source international coal include Germany’s RWE ( RWEG.DE ), Uniper ( UN01.DE ) and ENBW ( EBKG.DE ), Italy’s ENEL ( ENEI.MI ), Sweden’s Vattenfall, as well as Switzerland’s Axpo Holding.

“All coal derivatives markets have shrunken this year… as a result of lower options trading, and due to some counter parties that have become less active,” said Joachim Hall, cross commodity trader at RWE Supply & Trading, the trading arm of Germany’s biggest power supplier.

“Europe’s API2 (coal futures market) remains liquid, but it does not move in parallel with physical coal we buy in Asia,” Hall said.

VOLUMES DOWN, RISK UP

Noble’s troubles and Glencore’s strength are not the only reasons for the malaise.

Unlike many other markets, no single exchange has attracted enough liquidity to hedge reliably.

Instead bourses like ICE, CME and others including China’s Zhengzhou Commodity Exchange (ZCE), Singapore Exchange ( SGXL.SI ) or the European Energy Exchange ( T3PA.DE ) offer contracts with varying delivery options, differing underlying coal qualities, and in various currencies.

Chinese exchanges like ZCE have grown somewhat, but months can still pass without trades, and Chinese coal futures are problematic for international traders.

“There has been quite a bit of turmoil in the coal trading business,” said Ben Tait, analyst at British energy consultancy Prospex Research. “China is the driver. Its coal policy shifts can make prices soar or plunge. This has led to some big trading losses.”

Yet not everybody sees only doom and gloom.

RWE’s Hall said he hoped liquidity would gradually improve again over time, something Pat Markey, managing director of Singapore’s Sierra Vista Resources, also expected.

“The Asian market is poised for growth in financial trading, but this will take time as the Asian market is quite fragmented,” Markey said.

Coal – Futures, Options and OTC Clearing

CME Group is the exchange of choice for trading and clearing thermal coal futures and options. Since the listing of North American coal in 2001, CME Group has taken coal risk management global, offering a comprehensive product slate of both thermal and coking coal covering Europe, South Africa, Australia, Indonesia, China and the US.

Coal currently provides for over 40% of electricity generation and is essential for steel and cement production. With abundant reserves it remains an important component of the bulk commodity complex.

With the use of straight-through processing technology for clearing transactions through CME ClearPort, CME Group continues to work with the market to drive forward complete products and solutions for producers, consumers and traders worldwide. To promote effective price risk management for all active participants across the value chain, CME Group has introduced an ICI 4 indexed financially settled contract.

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