Using Coal Futures to Manage Uncertainty

Peter Keavey, CME Group
Risk management is more important than ever in today’s coal market. Cheap natural gas (NYMEX Henry Hub Natural Gas futures prices remain below $3.00) is competing fiercely with coal in the electricity bid stack. The fight to be the low-cost generator has become even more competitive in recent years, as the efficiency of gas-fired generation has steadily improved, while coal-fueled generation has remained relatively unchanged[1]. Proposed environmental regulations, including the EPA’s newly announced Clean Power Plan, which could lead to wide-scale coal plant retirements, are a major source of uncertainty for the future of the coal industry. While many threats to the coal business are difficult to manage, price risk – arguably the biggest determinant of profitability – can be effectively hedged using futures.

Coal Market Uncertainty
Historically, the majority of coal is transacted through long-term bilateral contracts. These contracts can either be priced using floating or fixed prices. Both of these pricing mechanisms present their own risks to buyers and sellers, which may be remedied through the use of futures.

Parties locked into a long-term floating price contract can choose to buy or sell futures in order to offset the risk of a move in the price of coal. For example, a coal producer whose revenue would fall from a decline in the price of coal would want to sell futures (take a short position), and therefore make a financial return when the price of coal falls. Conversely, a utility whose costs would rise with a coal price increase could hedge through buying coal futures (taking a long position).

While parties locked into fixed-price contracts do not face any immediate risk from a fluctuating coal price, futures may be employed in order to maintain market exposure. For example, a coal producer has signed a long-term coal contract with a utility at today’s market price. However, the coal producer is optimistic that the price of coal will rise and would like to benefit from that increase despite the fact that much of his future production is already sold under contract. Therefore, he buys futures, taking a long position on the price of coal. In summary, futures may be used to both protect a company from market price exposure, or to expose a company to market prices.

Futures Fundamentals
Futures are standardized contracts for the purchase and sale of physical commodities for future delivery on a regulated commodity futures exchange. A futures contract locks in the price of a commodity for delivery, or cash settlement, at a future date. By smoothing out the price a business pays or receives for coal, its costs, revenues and profits will be more predictable. The party who is the natural coal seller, the producer, would sell futures (short position), and the party who is the natural coal buyer, such as a power generator or exporter would buy futures (long position).

Coal futures can either be financially settled, like the NYMEX CSX futures and Powder River Basin futures, or physically delivered, like the Illinois Basin Coal futures. In physically delivered contracts, buyers of the contract who hold the contract until termination will be obligated to receive delivery of coal, and sellers of the contract will be obligated to make delivery. If participants do not want to make or take physical delivery, they may exit their positions by taking an equal and opposite position prior to termination.

I already buy or sell coal. Why would I want to use futures?
It’s important to note the difference between the role of both cash and futures markets. Cash markets, near-term transactions for physical commodities, help to get physical commodities from producers through distribution channels to end users, while futures markets exist to transfer price risk from those who wish to mitigate it to those willing to accept it.

There are numerous benefits to incorporating futures into your business plans, but perhaps the two most important are price discovery and risk transfer. Futures are traded in an open and transparent marketplace which provides the market with price discovery information. Futures allow companies to lock in prices, protect against counterparty risk and bring liquidity to the market.

Futures can help companies hedge their price risk. These tools are designed to protect coal sellers such as producers, against the risk of falling prices and coal buyers, such as utilities and exporters, against the risk of rising prices. Over the past few years, coal prices have fallen precipitously from 2011, when Central Appalachian coal was north of $80, to the low $40s today. Coal sellers which locked in prices during the high-priced years were able to prolong their profits as coal prices declined.

Coal Settlement Prices - Keavy - American Coal magazine Issue 2, 2015

Another important benefit of futures is their ability to protect companies from credit and counterparty risk. CME Clearing is the counterparty to every trade on one of our exchanges, removing the risk that the third party counterparty will default or not meet the agreed upon terms of a trade such as price, quantity, quality and timing of delivery. In today’s tumultuous coal market, the value of managing credit and counterparty risk cannot be overstated.

Also, standardized contracts encourage liquidity in the market. The greater the market’s liquidity, the easier it is to buy and sell, which in turn enables prices to better reflect supply and demand in the market.

Dealing with differences in quality specifications
Even if the quality of your coal differs from that of a particular coal futures contract, they can still be effective tools to help you manage your price risk. For example, if you are a utility that buys Illinois Basin Coal with a lower sulfur specification than that in the futures contract, buying Illinois Basin Coal futures allows you to lock in the price of a highly correlated product, letting you hedge most of your price risk. The difference of a physical commodity and the price of a futures contract is called basis. In addition to quality differences, transportation costs play into basis.

Conclusion
No matter your coal sales or procurement strategy, futures should be considered as an option in helping you achieve your desired level of market risk exposure. Depending on the strategy, futures may be used to either protect a company from market price exposure, or to expose a company to market prices. While the contract specifications of a futures contract need not be a perfect match to the physical characteristics of coal to serve as a hedge, it is important that a strong correlation exists between the price of physical coal and the price of futures.

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Peter Keavey is executive director, Head of North American Energy Products, CME Group (www.cmegroup.com/coal).

Futures trading is not suitable for all investors, and involves the risk of loss. Futures are a leveraged investment, and because only a percentage of a contract’s value is required to trade, it is possible to lose more than the amount of money deposited for a futures position. Therefore, traders should only use funds that they can afford to lose without affecting their lifestyles. And only a portion of those funds should be devoted to any one trade because they cannot expect to profit on every trade. There is no assurance that any of the trends mentioned will continue or forecasts will occur. Past performance is not indicative of future results.   This content is not to be construed as a recommendation or offer to buy or sell or the solicitation of an offer to buy or sell any derivative or to participate in any particular trading strategy.

[1] In 2003, the average heat rate of a coal-fueled power plant was 10,297 Btu/KWh while the average gas-fired power plant was 9,207 Btu/Kwh. Ten years later, the heat rate of the average coal plant had climbed slightly to 10,459 Btu/KWh, while the heat rate of the average gas generator fell to 7,948 Btu/KWh. Lower heat rates denote higher efficiency in converting fuel into power. http://www.eia.gov/electricity/annual/html/epa_08_01.html

24. January 2016 by Jason Hayes
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