METALLURGICAL COAL. HECTOR FORSTER Team Leader. Team Leader QUIET RIOT

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1 METALLURGICAL COAL JULIEN HALL HECTOR FORSTER Team Leader Team Leader QUIET RIOT IN THE METALLURGICAL COAL MARKET Often in the shadow of its higher-profile cousin iron ore, the metallurgical coal market is undergoing a quiet revolution. forced the market to pay ever more attention to pricing mechanisms and coal-blending techniques. Decades-old habits are giving way to new thinking in a range of arenas, as significant volatility and a push by miners to adopt shorter-term pricing has Iron ore quickly made the leap to spot price-based contracts from annual fixed prices, helping nurture a swaps and options market with rising volumes accounting for around a fifth of physical trade. The met coal market is taking a cue from iron ore, but developing at its own pace and its own terms. The complexity of the product s selection and use in sensitive coke ovens is proving this is one commodity for which it s difficult to standardize pricing. Pricing in the event of carryover tons when miners and buyers cannot perform the volumes agreed each period along with volatile steel demand and regular weather disruptions has the industry happy to find a medium between all contracts referencing spot prices and annual fixed pricing. Courtesy: istockphoto.com 14 Risk management and financial regulations are helping drive the market toward adopting spot prices.

2 Volatility drives pricing innovation Metallurgical coal prices used to be set once a year in protracted negotiations between Australia s leading miners with Japan and South Korea s large steel mills. Conversations often centered on likely changes in supply and demand in the coming year, and included a recap of the past year, resulting in a price both parties felt was acceptable. This status quo was shattered in April 2010 as the world s largest exporter, BHP Billiton-Mitsubishi Alliance, introduced quarterly pricing to its global customers in an effort to better reflect shorter-term market fluctuations. Other major miners immediately followed suit. A year later, BMA went one step further, bringing in monthly prices for the majority of its international buyers. BHP Billiton s move was unsurprising, being in line with outgoing CEO Marius Kloppers aim to achieve the price of day for all its commodities. Other major met coal producers, devoid of such guiding principles, did not follow. By sticking with the quarterly mechanism, they boosted market share from mills happier to use longer fixed-prices than the monthly price terms on offer from BMA. In the US, miners were able to offer customers a range of pricing terms, using flexibility as a way to win customers amid a surge in export volumes since By providing annual, six-month, quarterly and prompt monthly pricing alongside spot and tender-based offers, market share in countries such as Brazil and China grew at the expense of Australian and Canadian suppliers. PRICING MECHANISMS Selling to Pricing basis Large Asian steelmakers 50% Quarterly, 50% Monthly BHP Billiton-Mitsubishi Alliance Other steelmakers globally Monthly Asia-Pacifi c: Anglo American, Teck Coal, Global steelmakers Quarterly Peabody, Xstrata, Rio Tinto, Jellinbah, Wesfarmers, Vale Flat price Xstrata, Rio Tinto Semi-soft term buyers Semi-annual Major miners and traders, US: Asmin Koalindo Tuhup (Indonesia), Raspadskaya (Russia), Colombian miners term spot Source: Platts Alpha Natural Resources, the biggest US coking coal exporter, said last year that as early as April 20, 2012, 78% of expected met coal shipment volumes for 2012 of 22 million short tons had already been priced. As of January 25, 2013, 47% of shipments Alpha anticipated for 2013 had already been priced. Perhaps typically symptomatic of a market in transition, the resulting state of play globally is a patchwork of pricing mechanisms, with quarterly the most common system, seen side-by-side with monthly, annual and spot indexlinked pricing. Further complicating the picture, an increased number of spot index-linked trades are taking place globally. The main proponent has been BMA, which has sold floating spot cargoes priced against spot indices as well as Global steelmakers Term buyers Quarterly, Semi-annual, Annual, Monthly Flat price 15

3 similarly-priced long-term contracts with one or more European steelmakers. Such deals have also been observed in a wide range of met coal producing regions, including Colombia, Indonesia, Australia, Russia and Mozambique, mostly between miners and traders. Occasionally between steelmaker and steel user, or between coke maker and user, the use of the coking coal indexes in contracts is seen. Love me, tender Another sign of a maturing, increasingly transparent market is the recent emergence of spot tenders by miners. Here again, BMA led the way, floating two spot tenders for its flagship hard coking coal and PCI brands in late January Vale followed suit in early March 2013, floating a tender for its Carborough Downs HCC. Mid-sized miner Yancoal has also been a proponent of tenders throughout 2012 for its coking coal and PCI, though the company tends to restrict access to a handful of prefered traders. While these tenders are something of a novelty in met coal, in the iron ore market they have acted as a key contributor to increased transparency for over two years. Buyers in Turkey, Egypt, India and Brazil have actively held tenders for coking coals and coke, as they seek the lowest prices from suppliers competing on offers and several get enough interest to hold rounds. Miners agree to disagree So why has met coal s gradual pricing evolution been slower than iron ore s almost instantaneous jettisoning of the decades-old annual benchmark negotiation system in 2010? Besides the fact that metallurgical coal is generally a more complex commodity with more diverse global trade flows, one key reason stands out: a lack of consensus among major miners regarding their preferred pricing mechanism. In addition, China, the biggest spot buyer, is far more self-sufficient in met coal and has landlocked neighbor Mongolia to thank for plentiful supplies. This helps it act much more as a swing buyer of premium seaborne grades compared to iron ore, where it is more active on a far grander purchasing scale. As it stands, Anglo American, Teck Coal, Peabody, Xstrata and Rio Tinto appear to continue to support quarterly pricing, a system which many steelmakers globally also prefer, citing improved cost visibility. Lacking BHP s doctrinal emphasis on market pricing, these miners will be likely to evaluate new pricing systems mostly on their ability to boost balance sheets. And crucially, as spot prices have been on a near-continual decline for two years and mostly below term prices, any shorter-term pricing (spot-linked or monthly) would have yielded lower revenue for miners. Spot prices for premium hard coking coal in 2012 were on average $18.80/mt below the quarterly benchmark. Since April 2011, BMA s aggregated monthly pricing has so far exceeded the negotiated quarterly benchmark twice, and lost out six times. In the two years since the system started being used, a steelmaker purchasing exclusively on BMA s monthly basis would have paid $47.40/mt less than buying exclusively quarterly-priced premium HCC, or 16

4 about $6/mt per quarter, Platts calculates. With such a record, it is no surprise miners are rethinking the possible benefits of shorter-term pricing. Sell-side proponents of shorter-term pricing would argue that while monthly prices could appear to leave money on the table for one of the counterparties, the fact they better espouse immediate market fundamentals leads to generally improved contract performance, especially at times when spot and quarterly prices are wide apart. Some mills have criticized short-term met coal pricing, especially those needing long-term visibility on costs to align with steel price offers into long-term projects. The position of BMA on short-term pricing is totally opposite to ours, a European mill buyer remarked. The only way is to be less reliant on China-driven Australian producers for quarterly and monthly pricing coals and buy more on a long term basis from the US and CIS, the source said. Eurofer, the European steelmakers group, said the move to spot-based pricing led by China was a detriment to competitiveness. Rather than improving price stability and transparency, the new pricing systems resulted in high volatility with the risk of significant price increases, Eurofer said in a January document on coking coal. As far as the pricing mechanism is concerned, we get the impression from our members that EU steel companies are coping with the current mix of monthly contracts and spot buying, added Jeroen Vermeij, director of market TERM PRICES FOR MET COAL GUIDED BY SPOT PRICES... MOST OF THE TIME $/MT FOB AUSTRALIA Source: Platts $225 $225 $209 $330 analysis and economic studies at the Brussels-based group. $315 Apr-10 Aug-10 Dec-10 Apr-11 Aug-11 Dec-11 Apr-12 Aug-12 Dec-12 Mar-13 China s growing role as price setter Significantly, growing emphasis on the spot market in the last two years has eroded the price-setting power of Japan and South Korea s steelmaking behemoths, in favor of China the market of last resort and marginal buyer for seaborne exporters. In 2012, though supply disruptions had some effect, seaborne prices were mostly influenced by destocking and restocking cycles in China, a country which accounted for two thirds of Asia-Pacific spot hard coking coal deals. In the past three years, quarterly contracts have been on average within $4.80/mt of the spot price on the day of negotiation, highlighting that while these negotiations have taken place in Japan and Korea, the outcome was indirectly dictated by Chinese demand. $285 $235 $210 Spot premium low-vol HCC Quarterly contract price Negotiation $225 $170 $165 $172 17

5 While China s role has grown, the quarterly benchmark system has shown some flaws in recent months. As happened in Q3 2012, the latest quarterly settlements set by BMA and Nippon Steel & Sumitomo Metal Corporation at $172/mt for April-June this year has been widely rejected by most steelmakers outside of South Korea and Japan. European mills have been most vocal in their disagreement with the prices agreed in Asia, but other steel producers in India, Turkey, Brazil and Australia have expressed similar dissent. I still haven t got my head around why the Japanese agreed to $172/mt, an Australian steelmaker commented in early April. Sellers and buyers have increasingly asked the question of whether the benchmark system itself is dying, as it again fails to be applied globally, perhaps due to differing supply and demand dynamics in various regions. The common point between the two contentious quarters is the gap between spot and term pricing. Both settlements were signed while spot prices were declining sharply, leading to widespread buyer dissatisfaction just a few days after the deal was done. When this last happened, EU mills managed to win substantial discounts in some cases $10-15/mt from Australian and Canadian miners, and ended up paying less than their Asian counterparts. This looks likely to happen again, naturally raising the question of how relevant this pricing system is. Steelmakers drive for coke blend flexibility Steel producers globally are experimenting far more with their coal blends than seen in recent years for two main reasons. Ensuring operational continuity if a particular supply basin is taken out by a weather event, and to reduce costs. The Queensland floods of led to one of the sharpest price spikes on record, forcing steelmakers to scramble for alternative supplies. Anything black will do, one European steelmaker quipped at the time. This event, together with a similar Australian flood in 2008, created scarcity and extreme price volatility for certain types of coal, pushing mills to reexamine their overreliance on any given brand or coal type. Basically we want to create options, so that if there is a force majeure in one country, we can have options to buy from other suppliers. We want to create an immunity system against such issues, a large Indian steel mill source said. Of course, there are also some substantial cost-savings. Some market observers have compared this change to the transformation in the oil sector in the late 1970s and early 1980s, when a wave of investment enabled refineries globally to handle new streams of crude. Refiners had in the past been heavily reliant on local supplies, but depletion and price shocks drove them to reconfigure their plants, enhancing their blend flexibility. The adapted processing plants were said to have weathered subsequent market fluctuations better than the more rigid ones, and new refineries are now by default able to use more crudes than in the past. 18