METALSwww.platts.com/metals

APRIL 2016Jarek Mlodziejewski, TSI Senior Analyst

www.thesteelindex.com

COKING COAL: COMING TO TERMS WITH THE END OF THE CHINA BULL RUN

SPECIAL REPORT: METALS COKING COAL: COMING TO TERMS WITH THE END OF THE CHINA BULL RUN

2Copyright © 2016 by Platts, McGraw Hill Financial

Chinese steel consumption shrank in 2015 for the first time in decades. Prior to that, the consensus had been that output would expand every year. So the idea that China’s “peak steel” moment had already been reached took the steel world by surprise. This was particularly true for raw material suppliers, which had been investing in new capacity to meet continuing demand expansion.

The impact of the slowdown has been felt hard in coking coal markets where the effect of supply expansions created a market division. For a number of years there has been a ‘China price’ and a rest-of-world (ROW) price. This was driven by differing price elasticity between the Chinese import market, which happened to also be the world’s largest producer, and the coking coal-short ROW market.

Coking coal producers were caught between a rock and a hard place. They had extra tonnage to sell, but could not fetch the same price globally due to varying demand conditions. This created a CFR spot market and an FOB market, of approximately equal importance, which persisted for some time.

Regional market pricing differentials are the dichotomy at the heart of spot coking coal pricing which hinders market efficiency. But the market is now undergoing a change. The spot FOB market is asserting itself as the central pricing point worldwide.

This transition has seen index-linking increasingly pegged to TSI’s Premium coking coal FOB Australia index, which reflects an outright FOB pricing point. It has reportedly been embedded in most new physical coking coal index-linked contracts since Q4, 2014. Chinese end-buyers may still pay an all-in CFR price, but traders buy FOB.

As buyers congregate around the FOB-mark, will global pricing reconverge? It seems unlikely in this profit-thin steelmaking environment that ROW buyers will be content to subsidize Chinese buyers by paying higher prices, while Chinese buyers take the same material at lower rates. While that has helped miners amortize production costs over increased volumes, this situation may eventually force the producers to reconsider output levels.

Data submitted to TSI showcases the switch in the CFR/FOB dynamic. China import volumes fell 23% in 2015 to 48 million metric tons, but spot cargoes sold to China on a CFR basis fell 51%. So while China is taking less material, what it is buying is increasingly bought on a FOB basis.

With a unified purchasing point, the big question now is whether Chinese and ROW coking coal prices will ‘equalise’ i.e. be worth the same in either market, rather than varying by destination. They broadly are for low-vol coking coals, but mid-vols are a huge question mark.

This is not the only question vexing the market. The negotiated ‘benchmark’ system of quarterly pricing has persisted long after many had predicted its demise. The ‘stickiness’ of the negotiated benchmark has revolved around buyers’ interests in fixing some portion of steelmaking costs for each quarter to assist with margin management, particularly for automotive contracts which are often also settled quarterly.

Sellers have also had an incentive to continue pricing quarterly. In a market which has fallen for nine quarters, it has created a helpful lag in sales prices versus an ever-falling spot price.

Anglo American now takes the lead with quarterly benchmark negotiations, but given its prime assets are up for sale (with Foxleigh just sold), we could find the market in a vacuum where the quarterly system may collapse, encouraging more spot and spot-linked (indexed) sales.

Inevitably the spot price is more volatile than the quarterly negotiated benchmark, exhibiting swings as supply and demand for coking coal fluctuates.

But as an active iron ore derivatives market has shown, this does not mean suppliers, traders and end-users give up control of revenues and costs to the whims of a volatile spot market. Instead, buyers and sellers can lock-in future pricing (e.g. monthly, quarterly, annually) as far along the forward curve as they wish. The growth of the coking coal derivatives market is evidence of this occurring as market participants mitigate the risk of fluctuating spot prices.

TSI SUBMITTED VOLUMES � PREMIUM COKING COAL

Source: TSI

Q1 16Q3 15Q1 15Q3 14Q1 14

FOB Australia CFR China

EXCHANGE TRADED DERIVATIVE VOLUMES(’000 mt)

Source: TSI

0

100

200

300

400

Mar-16Jan-16Nov-15Sep-15Jul-15May-15Mar-15Jan-15

CME SGX

SPECIAL REPORT: METALS COKING COAL: COMING TO TERMS WITH THE END OF THE CHINA BULL RUN

3Copyright © 2016 by Platts, McGraw Hill Financial

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It has been a good start to 2016 for coking coal derivative volumes. Cumulative Q1 2016 volumes grew 87% over Q4 2015 and 71% over Q1 2015. Yet, while growth is encouraging, average monthly volumes for the last two years across both CME and the Singapore Exchange (SGX) are about 240,000 mt. Coking coal futures have yet to experience the explosive growth of iron ore, missing that core of market makers willing to build volume to create the critical liquidity levels needed to attract the participation of others.

For those willing to hedge significant coking coal volumes (and there are plenty) they can take some heart from the

history of iron ore derivatives market maturation. Once the traditional fixed annual iron ore pricing mechanism transitioned into the use of shorter term contracts in 2010, paper trading on SGX doubled.

It has also continued to double every year since then, providing new market participants with confidence to trade in the product. As the market begins to seriously contemplate the end of the quarterly negotiated benchmark system that may provide the spark needed to start the evolution of a physical and paper market that has been in a holding pattern for the past few years.