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Timespread opportunities to be found amid volatile coal markets

The CIF ARA thermal coal market continues to move into backwardation. Any short term oil-led rallies in the back end could present a selling opportunity, while there lies greater relative upside risk to the front end of the curve.

"The Atlantic market will likely remain oversupplied in the near term and, against a backdrop of low demand, it is unlikely that prices will have sustainable rallies. Strength is likely to be sold into, especially further out the curve." - UK Power Pilot, 19th Aug 2015

As the market trades lower, backwardation may increase but the entire curve trades structurally lower simultaneously. This will enable a trader to leg into long timespread positions. While the Q4-15/Cal-16 spread is popular at the moment for traders with limited insight into the physical market, trading the Q1-16/Cal-16 paper may provide a lower risk, higher reward opportunity.

Q1, as a part of the winter period, is susceptible to cold snaps. Furthermore, there is potential for further declines on the Cal-16 with coal-fired retirements at the back end of that year weighing down on demand in Europe. The spread is currently trading close to flat, and based on our analysis, could be backwardated by 50 cents within the next two months.

The near end of the curve has greater upside relative to the back:

1) Short-term supply constraints (e.g. Fenoco night-time rail ban, strikes in Colombia etc.)

2) Short term demand spikes (weather driven, physical short squeeze)

3) Physical/paper trading positions run by large traders/utilities that bid up the front of the curve.

On the far end of the curve, the market continues to be oversupplied in the medium to long term, while weakness from Asia will add to the oversupply in the global seaborne market. A depreciation in currencies of coal-producing countries will cushion margins as US dollar-denominated coal prices fall, creating a slow spiral downwards towards a theoretical absolute marginal cost level plus freight, which we have pegged in the mid to low $40s/mt for the CIF ARA market.

Considering the contango collapsed months ago as the market came to terms with the fact that the spot kept out-turning at weak levels and the bearish long-term fundamentals actually will keep prices low, we must caution against significant persistence of backwardation, especially post winter (Q1-16).

The curve is likely to mean revert at some point to close to flat with a level of backwardation that is not extreme. The risk premium on the front end of the curve will continue to be judged constantly, on the back of which the market will determine where timespreads should be fairly valued.

source: http://www.platts.com