The term ‘trading’ often conjures up images of a swashbuckling, testosterone-laden trader placing bets in casino-like trading pits. While speculators play a vital role in the over-the-counter (OTC) market, without hedgers – those participants that use the trading arena to protect their organizations from market gyrations - trading is unlikely to develop. Coal hedgers comprise companies whose revenues, costs and/or assets fluctuate inversely to the price of coal. Hedgers include some obvious and not-so-obvious players:
coal producers and coal consumers;
owners of coal reserves;
exporters and importers;
investors in coal companies and creditors to coal companies;
power plant developers;
import and export terminals;
transportation providers (rail, ship, barge, truck);
competing fuel producers (natural gas, oil, petcoke); and
Some of these players are more directly affected by swings in coal prices than others. However, all of these players have a horse in the race. While a mine manager has the more jugular task of protecting the safety of a workforce, the hedger has the task of protecting the organization’s financial health. How does he/she achieve this? The hedger reduces risk by using a variety of OTC products - indexed transactions, standardized contracts, put/call options, swaps, basis trades and structured products tailored to achieve specific risk mitigation.
In a nutshell, the objective is to create a hedge with a value that changes inversely to the value of the underlying coal. If you are a producer and you are trying to lock in a $70 sales price, your hedge in the OTC market might be to sell a $70 standardized contract. If the market drops to $50, you will be selling your coal for $20 less, but instead of getting your tail kicked by your boss, you will be getting pat on the back because your hedge has risen by $20 (see Table 1).
At this point you are probably asking yourself: “Why wouldn’t I just skip the hedge and sell to my customer for $70?” Good question! Maybe your customer is delaying negotiations and is waiting for the price to fall. Maybe your customer hedged their fixed-price in the swap market and will purchase spot coal in 2005 (next issue’s topic!). Maybe you are hedging for strategic reasons - your management wants you to stealthily lock in the price in the OTC market and eliminate knocking on your customers’ doors with coal to sell (thereby creating the illusion of less volume on the market). The reasons for hedging are almost endless.
As mentioned earlier, speculators play a vital role in the OTC market - they are always there to take the other side of a transaction. Think about it. You have companies that want protection against prices rising and companies that want protection against prices falling. Why do you need speculators? Because some companies are concerned about prices in the immediate future and others are concerned about prices one to two years in advance. Some companies want to take action in the beginning of the year and others want to take action toward the end of the year. Some companies have small volumes to manage while others have huge volumes. Some companies want protection and they want to benefit from favorable market moves, while others are willing to exist within a price range and simply want a floor and ceiling price. Speculators are experts at taking on risk. They then slice, dice, repackage and maybe even live with some residual risk. In general, most speculators fall into one or more of three categories:
Market makers: these are the companies that provide the market with selling prices (offers) and buying prices (bids) for most OTC products. If they remember to buy low and sell high, they usually do quite well. Market makers are often financial institutions which are providing a service to their clients (coal producers, utilities, hedge funds, investors, creditors, distressed debt players, etc.)
Directional traders: these are the companies that trade based on directional views - the market will rise or fall. In actuality, most traders’ directional strategies are more complex, for example Newcastle will rise and Richards Bay will fall; CSX 2005 will fall and CSX 2006 will fall but not to the same degree.
Energy marketers: this group engages in coal trades as part of a broader strategy which includes locking in electricity margins (spark spreads), providing hedgers with pre-packaged risk management products and executing inter-fuel arbitrage strategies.
No overview of the OTC market would be complete without including OTC brokers. This often misunderstood group provides the lifeblood to the OTC market in the form of:
the highest bids and lowest offers;
efficient and speedy trade execution;
anonymity (prior to execution);
inexpensive transaction costs (pennies per ton);
recorded transactions and written confirmations; and
spreading of the trading ‘gospel’ to traditional market participants.
Over-the-counter brokers are market-neutral – they never take positions. These brokers continually canvas the market for the highest bid and lowest offer. They broadcast this information to potential counterparties around the globe. When they find a buyer for the lowest offer or a seller for the highest bid, they match the two together and the counterparties enter into a trade. There is no further negotiation because OTC market participants have already accepted the standardized specifications, terms and conditions. Credit is not an issue because brokers will only match up counterparties that have credit approvals in place. In cases where the two counterparties do not have credit in place, they may mutually agree to the trade ‘subject to credit’
Over-the-counter brokers work hard for their few pennies per trade (paid by both sides of the trade). In a market which is continually fluctuating according to supply and demand drivers and changing price sentiments, brokers must continually elicit the highest bids and lowest offers on various products (Globally: API 2, API4, NEWC, RB1 and several physical products; US: CSX 12500 1%, Nymex look-alike, PRB 8800, PRB 8400, several secondary products and a newly developing swap market). It is a non-stop job.
There is much more to trading, but not in this issue! There are many reasons to enter into an OTC trade depending on whether you are a speculator or a hedger. For the coal miner, the focus should be on protecting (hedging) the core assets. The same risk-averse principles which are used to ensure the safety of your miners are used by the hedger to protect the financial health of the company.
Stephen Doyle is the president of Doyle Trading Consultants which advise the energy and financial sectors on risk management matters related to the coal industry. Your comments and questions are welcomed - firstname.lastname@example.org