Trading Physical Coal in a Dynamic World Market

Trading Physical Coal in a Dynamic World Market A CommodityPoint White Paper

Prepared by UtiliPoint速 s.r.o Prikop 4 602 00 Brno +42 0533 433 658 www.utilipoint.com September, 2011 1

Table of Contents Introduction ...................................................................................3

A Bright Future ......................................................................4

Operational Risks and Coal Trading: 4 Big Issues ...................5

Tracking Complex Trades ......................................................5

Physically Tracking Coal ........................................................6 Freight Challenges .................................................................6 Risk Management and Hedging ...........................................7

SolArc RightAngle Delivers Real Benefits for Physical Coal Traders .............................................................8 Summary ..........................................................................................9 About CommodityPoint ...............................................................9 About UtiliPoint International, Inc. ...........................................9 About SolArc, Inc. .......................................................................10 About the Author ........................................................................10

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Introduction In the last several years, new fundamentals have clearly emerged in global coal markets. Rapidly rising demand from China and India, along with the renaissance of coal-fired power generation in Europe, has resulted in significant increases in ocean freight rates and coal export prices. These increases have led to larger trade flows and significantly higher price volatility, yet created a more vibrant international coal market. Although the coal market offers significant opportunity, it is also fraught with significant risks, especially on the operational side, as a result of the sheer complexity of coal trading and logistics.

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A Bright Future Global demand for coal, in part as a result of the growing energy needs of China and India, has driven coal prices higher and made them increasingly volatile. In 2010, China became a net importer of coal despite its own huge reserves, importing 50 million tons of coal (a 130% increase compared to the previous year), and yet, it still experienced shortages as thermal coal stockpiles at various plants fell below required levels.

India’s demand for coal is a similar story as the nation relies on the fuel for 55% of its energy needs. It imported 60 million tons of thermal coal in 2009, up over 100% compared to the previous year. India plans to double its power generation capacity by 2012, which could result in it requiring some 200 million tons of imported coal annually.

Figure 1: World Coal Consumption Forecast, 1990-2030 Source: EIA, IEO 2008

Quadrillion Btu

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For many across the industry, this all adds up to increased risks in trading coal, particularly physical coal. While coal traders face the usual run-of-themarket credit and regulatory risks, increased volatility, the potential for stricter regulation and oversights, and remaining credit issues make these risks even more complex. In addition, physical traders cope with operational risks, which are significant and must be closely monitored and mitigated.

India China United States Rest of World

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Regardless of the production level or demand outlook, the fact remains that coal has an associated environmental impact. Coal-fired generation is under heavy pressure to clean up operations, and many facilities have. Such pressure may mean the closure of older coal-fired generation facilities and their replacement with more modern, cleaner generators.

Generators that are more efficient reduce CO2 emissions, resulting in a lower environmental impact.

A change to lessen the environmental impact could also mean a greater demand for certain grades of coal than for others and a price premium accordingly.

1990 2000 2005 2010 2015 2020 2025 2030

According to the US Energy Information Agency, US coal exports rose 49% during the first quarter of 2011 from the same quarter a year ago, pushing exports to their highest quarterly levels since 1992.

One factor behind this increased demand for US coal is the disruption in global coal supply caused by natural disasters, including typhoons and flooding in Australia as well as the earthquakes in Japan. These natural disasters resulted in reduced coal production.

Meanwhile, decisions by various governments to exit or curtail nuclear power options in the wake of the Japanese disaster brought coal increased prominence in Europe as a likely replacement despite its associated environmental issues. This supply and demand picture has not only resulted in increased prices but also in increased volatility.

“In 2010, China became a net importer of coal despite its own huge reserves, importing 50 million tons of coal (a 130% increase compared to the previous year), and yet, it still experienced shortages as thermal coal stockpiles at various plants fell below required levels.�

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Operational Risks and Coal Trading: Four Big Issues Coal is a bulky fuel that must be transported from its point of origination to point of use with the potential to use many different shipment methods, including barge, vessel, rail, and truck. It is also of variable quality and grade. These characteristics must be tracked as the coal is transported, even as it is temporarily stored and mixed with coal from other sources along the way. The specification of the coal is usually a part of the sale or purchase contract and a component in pricing. It is very important that quality and grade are tracked, primarily through the use of lab analyses conducted at various stages across the supply chain. Inefficiencies or mismanagement in any part of the transaction may result in additional costs or lost profits for the trading company.

A trading company purchasing coal of varying grades from multiple sources that then transports the coal to various points of sale or end use is faced with a very complex set of operational risks which may be grouped into the following four specific categories: • • • •

Tracking Complex Trades Physically Tracking Coal Freight Challenges Risk Management and Hedging

Tracking Complex Trades Tracking coal trades is a complex activity due to the possible variations in contract terms or product specifications, such as: pricing indexes and formulae, various product specifications, and delivery timing.

Coal prices can be adjusted based on the actual quality of the coal measured using laboratory analysis results across a range of different quality factors, including ash, sulphur, or boron contents, moisture, or calorific values, just to name a few. This type of data must be consistently specified, validated, and tracked.

Problems in the recording and tracking of trade data, such as delivery date, quality and/or grade, as well as

issues in the processing and capture of all required documentation along the way, can result in pricing changes or other penalties, making it imperative that the trade data is correctly captured and tracked at all times along the value chain at an appropriate level of detail.

In 2001, globalCOAL, the world’s leading online coal trading platform, introduced the Standard Coal Trading Agreement (SCoTA®) in an attempt to change the way business is conducted in coal markets by enabling the creation of tradable standard coal products. The SCoTA acts as a “Master Agreement” and provides a single, accepted set of terms and conditions and a range of coal quality specifications and delivery points for international coal sales and purchases. Its use in the industry has increased significantly over the last five years, and SCoTA is now used globally as the contract of choice by coal producers, consumers, and traders for both screen trading and in bilateral transactions.

However, SCoTA is constantly being revised and enhanced in response to market developments to ensure that it remains relevant, effective, and captures new market opportunities. The SCoTA products are quite numerous with complex criteria specified for a number of quality constraints, each of which needs to be properly recorded and tracked. The latest version of the contract, SCoTA v7, was released in June 2009. So, while SCoTA makes progressive strides towards improving the challenge of tracking detailed trades, it is not a complete solution to such a complex issue.

“Problems in the recording and tracking of trade data...[make] it imperative that the trade data is correctly stored and tracked at all times at an appropriate level of detail.”

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or end user site. The challenge with coal pile blending is that characteristics such as sulfur content, fly ash, heat content, etc., must be tracked and optimized concurrently.

Physically Tracking Coal Trading companies need to be able to track the entire transaction from trade to delivery, managing coal stock balances by origin, grade, and quality at a variety of locations that might include storage, shipping terminals, receipt/delivery locations, as well as while in transit. Companies routinely struggle to manage inventory levels and qualities accurately, hindering their ability to forecast fuel costs at plants or to optimize coal purchasing activities and rolling inventory. This problem further impacts their ability to perform blending to meet their burn and emission requirements properly. Improvements in tracking inventory quantities and qualities require the ability to track and verify quality and quantity data, along with associated laboratory analyses, at a sufficiently granular level.

Coal pile management is also a challenge as the inventory requirements are balanced against transportation limitations and the availability of coal that meets required specifications. The risks associated with a single coal source (mining and associated transportation limitations) can be mitigated with coal pile blending, which allows coals from various sources to be secured. By evaluating the lab analyses of these various coals and blending the coal piles to achieve the desired specifications, a diversity of sources and transportation methods can be introduced into the procurement model. Acquiring coal from different geographic regions reduces the transportation challenge, although at first glance it might appear that more transportation methods would increase the challenge. The greater risk is having only a single supply source. If that source goes down or if transport from that source is hindered, the company is at risk.

By having more options, a company reduces the dependence on the single source and therefore the risk. Blending can be handled at the terminal, dock,

Another operational risk or challenge is the ability to actualize movements. This actualization is required to identify the exact shipped quantities and imbalances as well as to track losses and other discrepancies. This allows for the management of delivery performance exposure to individual producers, brokers, or mines.

Freight Challenges Because coal can be transported in such a variety of ways, it is important for trading firms to be able to uniquely identify each shipment and have the ability to price out the transport based on transport type and freight route. As a result of so many options and routes, trading firms deal with a high volume of various transportation agreements and carriers.

Such complexity poses challenges in tracking and optimizing the actual usage of the transportation agreements. Companies struggle with effectively managing carrier activity by quantity, origin, or destination. They also face the problem of potentially owning or leasing too much capacity, high maintenance costs, or tied up capital as a result of difficulty they have managing their high volume of agreements.

Similarly, supplier quality is difficult to track as there is no way to accurately monitor ongoing quality issues, and lab analyses cannot be easily tied back to the coal delivered by a particular supplier. Shipments can often be late, creating penalties, especially if there is little capability to track railroad load and unload dates by carrier or report “in-transit� inventory by carrier.

Visibility into Forward Freight Agreements is critical in the international market. Global coal traders must understand decomposing freight risks into fuel and time chartering. This understanding is a key challenge in managing freight logistics. Transportation reliability and availability must be factored in since 6

procurement is typically at the mine, allowing the vagaries of transportation scheduling by rail or barge to potentially impact inventory. Varying rail and barge rate schedules need to be understood in the inherent costs of coal procurement. Transportation can be adversely impacted by weather, thus impacting delivery schedules. These transportation constraints pose additional challenges to the security of a sound coal inventory.

Risk Management and Hedging Given the trading complexities of both the coal and freight markets and the unique risks associated with each, the ability to analyze, manage, and hedge current and forward trading positions with realtime information is critical to a company’s ability to capture margin along the entire supply chain.

Companies need forward position reporting in order to take advantage of market opportunities. This need requires visibility into forward consumption, prices, costs, forward physical positions, and forward price curves. As a result, some companies cannot optimize

coal versus gas plants at their power generation facilities because they lack visibility into fuel costs at the plants, forward physical fuel positions, forecast consumption, and/or fuel costs in forward positions.

Another key solution requirement is the ability to understand profitability through the accurate tracking of coal quantities and costs across the supply chain from the point of origin to the point of sale or end use. In fact, physical coal traders are often exposed to many more risks than those discussed above, depending on their specific circumstances.

Essentially, these operational issues boil down to the same problem: the challenge of tracking sufficient transaction detail with the ability to drill down into that data on a timely basis.

Finally, companies running multiple systems have additional issues and exposures stemming from entering the same data into each different system with the potential for error and abuse as well as increased personnel costs.

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SolArc RightAngle® Delivers Real Benefits for Physical Coal Traders SolArc’s RightAngle solution is extensively utilized by coal trading firms due to its robust abilities and its proven capability of tackling the complexities previously described. SolArc RightAngle allows users to track sufficient transaction detail via audit trails in order to access required data on a timely basis based on any number of criteria. It features a solid design and architecture which utilizes a single, central location to capture supply/demand, in-transit shipments, and actual and planned inventories, thus optimizing inventory. Its comprehensive inventory and scheduling tools help perform a variety of complicated tasks smoothly, including inventory valuation for both estimated and actual quantities, utilizing a “best available quantity” concept to ensure that users always have access to the most accurate data.

In CommodityPoint’s 2009 ETRM Vendor Perception Study, SolArc was ranked as the market leader in coal for North America by a sample of the industry. With the resurgence of coal worldwide, RightAngle offers a solution to many of the issues discussed in this paper because of its design and thoroughness when it comes to modeling the complexities of coal and numerous other commodities.

Figure 2: 2009 ETRM Vendor Perception Study, CommodityPoint – Perceived Market Leadership - Coal Unknown Triple Point SunGard Energy Allegro OLF SolArc None

While having a data structure to capture trades is imperative, having a process flow that models a company’s business allows them to avoid financial restatement. SolArc RightAngle provides such capabilities and value. Companies want to avoid restatement for a variety of reasons not limited to but including: • Destruction of investor and bank confidence; • Under various governments’ regulations, restatement could have severe implications for company executives; and • At a minimum, companies could face significant refiling fees with their country’s respective trading commissions.

Example: a trading company that bought a physical product and then sold it, moving it from point A to point B, still has exposure until the product is delivered. SolArc RightAngle provides the markto-market in-transit visibility which provides unique transparency and allows companies to avoid restatement.

RightAngle captures fuel costs through inventory valuation and mark-to-market reporting and tracks coal quality data via complete lab analysis capture.

This ability provides strong, flexible reporting, including, supplier performance reports, demand reports, and inventory reports as examples. Flexible position reporting offers corporate, group, and individual views of hub activities by location and by business strategy.

RightAngle’s focus on capturing the detail of the physical and operational side of the business provides users with real-time information needed to uncover opportunities and identify cost savings and efficiencies. In short, it helps manage the wide variety of operational and physical risks associated with trading coal.

ETRM Market Perception study – North America & Europe, CommodityPoint, 2009 Report

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Summary Effectively managing associated operational risks involved in physical coal operations is a key to delivering optimal profits and controlling costs.

Today’s coal markets are more volatile than ever, and that volatility seems set to continue given the fundamentals at play. Therefore, it is imperative that physical coal trading firms have a strong grasp on all aspects of their operations and manage them effectively. The coal trading market views SolArc RightAngle as a leading solution for coal in its ability to assist trading firms in managing today’s challenges and risks.

SolArc RightAngle, by design, allows its users to capture all of the necessary details to track quantity and costs across the coal value chain. It also provides easy access to captured information, allowing users to manage their operations efficiently, control their costs, and maximize their profits. Using RightAngle as a single platform reduces other risks such as errors, omissions, and potential abuse. It is a proven, robust solution utilized by many of the world’s leading physical coal trading firms.

About CommodityPoint CommodityPoint is a division of leading energy and utilities analyst and consulting firm, UtiliPoint International, Inc. CommodityPoint provides Commodity Trading & Risk Management (CTRM) research, analysis, and consulting services. Its services bring insight into business issues, trends, processes, and technology to energy companies, utilities, banks, brokers, funds, investors, and vendors, enhancing their competitive position and supporting critical business decisions. CommodityPoint has been formed to bring focus and clarity to the broad array of issues

surrounding the wholesale trading of commodities.

Its team provides expert analysis of market trends and, in particular, the technologies and applications supporting those that participate in regional or global commodity markets. The principal analyst, Dr. Gary M. Vasey, brings years of practical experience to his role. With offices in Europe and the US and backed by an experienced research team, this organization provides an unparalleled view of the marketplace. www.commodity‐point.com

About UtiliPoint International, Inc. UtiliPoint is an energy-focused research and advisory firm, providing research-based information and analysis to energy companies, utilities, investors, regulators, vendors, and service suppliers to the industry. The organization is comprised of industry experts in North America and Europe with diverse backgrounds in Smart Grid, meter-to-cash processes and systems, utility generation, transmission and

distribution, retail markets, regulatory affairs, and international energy issues.

UtiliPoint is a wholly owned subsidiary of Midas Medici Group Holdings, Inc. www.utilipoint.com

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About SolArc, Inc. SolArc, Inc. is a global provider of enterprise commodity trading and risk management software solutions. SolArc’s flagship product, RightAngle, offers customers greater insight and control over complex commodity supply, marketing, and trading environments, delivering increased operational effectiveness and profitability with lower risk.

Established in 1991, SolArc is a trusted solution provider for an international clientele of more than 90 leading corporations, with more than 7500 active users, across a range of vertical industries, including energy and utilities, aviation and transportation, banking and finance, agriculture and consumer goods.

SolArc is headquartered in Houston, Texas with offices in Dallas, Texas; Tulsa, Oklahoma; New York City, New York; London, England; and Singapore.

For more information, please visit www.solarc.com or contact: John Scherb, Director Global Demand Generation 55 Waugh Dr. Suite 300 Houston, Texas 77007 Office (713) 260-5166 Cell (281) 830-7369

About the Author Gary M. Vasey, Ph.D. Managing Director, CommodityPoint Dr. Gary M. Vasey is an industry expert noted for his industry analysis, consulting, and marketing skills. Gary currently manages UtiliPoint’s CommodityPoint Division from our office in the Czech Republic. With over 24-years experience in the energy, utilities and commodities industry, Gary has experienced the industry’s volatility as a geologist, consultant, software developer, analyst and marketing practitioner providing him with unique insights, not just into the entire value chain, but also into how to position, brand and deliver products and services to the industry. He is a noted expert on the commodity trading, transaction and risk management software industry and an accomplished industry analyst and thought leader.

Gary has published more than 500 articles on industry trends in a variety of publications, is a regular speaker at industry conferences and the co-author of the UtiliPoint expert series books ‘Trends in Energy Trading, Transaction and Risk Management Software

- A Primer’ and ‘Selecting and Implementing Energy Trading, Transaction and Risk Management Software - A Primer’ . He also contributed two chapters to ‘The Professional Risk Managers‘ Guide to Energy and Environmental Markets’ published by PRMIA and two chapters, co-written with Peter C. Fusaro, to ‘Weather, Energy and Environmental Hedging - An Introduction’ (ICFAI University Press, 2007) edited

by Amando F C Da Silva.

Gary is also the co-founder of the Energy Hedge Fund Center (www.energyhedgefunds.com) and the co-author of ‘Energy & Environmental Hedge Funds - The New Investment Paradigm’ (Wiley, 2006) with Peter C. Fusaro and of many trade press articles on hedge funds in the energy industry.

Gary holds a B.Sc. (Hons.) degree in Geological Sciences from the University of Aston in Birmingham, England and a Ph.D. in Geology from the University of Strathclyde, Scotland.

SolArc and RightAngle are registered trademarks of SolArc, Inc. All other marks, names, and logos used or referred to herein are the property of their respective owners.

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