Credit Suisse completed the first ever cleared coking coal swap transaction yesterday, in a development that should enable steel mills to hedge their exposure to their entire floating costs.
The closing of the transaction early yesterday morning was the culmination of two-and-a-half years of work to identify appropriate reference indices and sufficient liquidity, Kristian Thunes, Credit Suisse’s global head of freight and iron ore, told FinanceAsia. It marks one step closer to “eventually creating a proxy contract for steel by combining iron ore and coking coal contracts”, he said.
The significance should be especially acute in Asia. Australia is the biggest exporter of coking coal, while Indonesia is also an important supplier. The biggest buyers are in Japan, Korea and, increasingly, India. China, on the other hand, is able to tap into the coking coal reserves of neighbouring Mongolia.
Indeed, Asia’s importance motivated Thunes and his team to re-locate to Singapore a year ago.
“Steel is a world growth product. This region is where the big producers of raw materials [iron ore and coking coal] are based as well as the major manufacturers of steel.”
The over-the-counter contract was made with a “major coal industry participant”, who swapped exposure to floating coking prices for exposure to a fixed price. Coking coal prices are normally determined on a quarterly or monthly basis, but there is increasing pressure from producers to use the spot price.
The transaction has a six-month tenor and net payments will be made monthly. The contract, launched by the CME Group, was for 60,000 tonnes, with a nominal cash value of $17.34 million based on a spot price of $289 per tonne and references the Platts Australian coking coal index. It is listed on Nymex as Australian Coking Coal (Platts) Low Vol Swap Futures (ALW), with clearing services available through CME ClearPort. A similar contract referencing the Argus index (ACR) is also available.
Credit Suisse is confident that it will manage its risk as further participants join the new market. It has already received interest from other clients so there should be opportunities to hedge its exposure.
“Coking coal swaps are a breakthrough in risk management for the steel industry,” said Thunes. “This is the missing piece of the jigsaw puzzle that enables mills to hedge all of their variable costs. We believe steel mills will find this a very valuable risk management tool, especially since coking coal prices have been quite volatile in recent years, and would expect coking coal swap volumes to increase rapidly.”
Typically fixed costs make up about 20% of a steel mill’s outlays, and the remaining 80% of variable costs are largely iron ore (32%) and coking coal prices (19%).
Credit Suisse was involved with the first iron ore swaps in 2008 and completed the first iron ore swap contract with a Japanese counterparty in June 2010. With the addition of coking coal swaps, “steel mills will now be able to hedge exposure to all their floating input costs, which encompass iron ore, metallurgical coal, power and scrap”, said Thunes.
But, the contracts have a potentially broad range of applications for all steel industry participants.
Producers could use the instrument to sell forward at price peaks or when margins are strong, hedge market risk in project financings or convert fixed price revenues back to floating rate.
Traders could use the contracts to protect profit margins on cargos traded as principal, or offer fixed pricing to customers when buying at floating prices under contract. And steel consumers could hedge contracts linked to raw materials and buy forward to protect long-term margins, while financial investors could also use these swaps to express a market view, diversify from commodities indices or hedge equity exposure, said Thunes.