November 7, 2016

Coal price dump and jump in animation

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Spot coal prices continue to surge around the world. As winter approaches, Pacific Basin steaming coal prices have broken above 100 $/tonne. Coking coal prices are above 250 $/t.

The price action in the coal market is being driven by Chinese demand. Power plant coal inventories in China are relatively low heading into winter. Chinese steel production is also recovering at an unexpected pace.

Asian tightness is feeding through into European coal pricing, with the ARA coal price benchmark topping 85 $/t last week. Rising coal prices are reshaping the fuel cost balance in European power and gas markets.

The competitive advantage that coal fired generators have enjoyed over CCGTs for most of this decade is rapidly being eroded. Higher coal prices have supported a surge in CCGT load factors in 2016 (supported by extended nuclear outages in France). European power sector gas burn has been particularly robust since the summer, running at levels more than 50% above last year.

The sustainability of the current coal price rally looks to be one of the defining factors for European energy markets heading into 2017. So today we look at an animated view of the evolution of coal prices this decade for clues on what lies ahead.

Back to the movies: coal in animation

We have previously published animations of the spot and forward price evolution of Brent, NBP gas and UK sparkspreads. Chart 1 applies to same technique to the evolution of ARA coal prices since 2010.

Chart 1: Animated evolution of European (ARA) spot and forward coal prices (2010-2016)

Source: Timera Energy (based on ICE data)

Some interesting characteristics from the animation:

  • Parallel shifts: There is a very strong correlation between movements in spot prices and forward prices. In other words spot tends to drive the curve. This is a characteristic that we have shown previously with crude, gas and power prices, and a great illustration of why forward prices are not a good forecast for future spot prices.
  • Curve slope: The shape of the coal curve has undergone a transformation as the decade has progressed. From 2010-14 the coal curve was predominantly in contango (upward slope), reflecting a positive convenience yield. But as the market tipped into a more pronounced state of oversupply from 2015, the curve flattened and then shifted into backwardation (downward slope). This is consistent with market expectations of continuing oversupply.
  • Occasional prompt stress: There are occasional periods of deviations of prices in the front 3 months of the curve from the rest of the curve. These are typically short lived, with either the curve ‘catching up’ or spot ‘falling back in line’, and indicate some temporary shock to the supply/demand balance.
  • Current shape: The current shape of the curve shows quite extreme states of both backwardation and prompt stress. Spot prices sit at about a 30% premium to 2018 forward prices. The majority of that premium is located across the current winter period. History suggests to us that there is likely to be an imminent transformation in curve shape.

A self-defeating rally?

Coal supply, as for many other commodities, tends to be inelastic over the short term (i.e. it is relatively unresponsive to price). The accelerating pace of the price surge over the last three months has all the hallmarks of a market being driven up an inelastic short term supply curve. This is consistent with price insensitive Chinese buying given low inventories and a cold start to winter.

Supply may not be able to respond immediately, but it is unlikely to take too long. A key factor supporting the 2016 recovery in prices has been Chinese policy to reduce a glut of domestic production. The Q4 price rally has already seen China materially soften its policy stance on mine closures.

There is also strong recent evidence of market supply reaction from big coal producers. For example at least 8 mines are in the process of being re-opened in Australia. Most of these are anticipated to be producing by the end of this quarter or early in Q1.

The blistering rally in commodity prices since February 2016 has steamrolled bearish market sentiment. Coal has seen the sharpest rally of all. But current extreme backwardation in the coal curve suggests to us that the recent rally may be close to a near term peak.

Article written by David Stokes & Olly Spinks

Coal price dump and jump in animation