Coking Gold

“Alchemy is a kind of philosophy: a kind of thinking that leads to a way of understanding.” – Marcel Duchamp

A funny thing occurred in the gold market during March of 2020. If you happened to be in New York and in possession of four 100-ounce gold bars, you could have traded those bars for one 400-ounce gold bar plus a handsome premium – some say as much as $100 an ounce. That ~6% divergence in price was highly unusual. Gold is gold, after all, so why should the exact same amount of gold sell for different prices?

The difference arose from how contracts are settled in New York (on the COMEX) versus London (on the London Bullion Market Association, or LBMA). COMEX contracts are settled with 100-ounce gold bars, whereas LBMA contracts use the 400-ounce variety. In normal times, gold is flown around the world in various forms to facilitate such settlements and the difference in price per ounce between the two bar weights is minimal. But as we all know, March of 2020 was anything but a normal time. Planes were not flying because of the Covid lockdowns, and the situation was made worse because certain refineries that made 100-ounce bars were forced to close. If you were short gold on the COMEX, you needed to deliver 100-ounce gold bars to settle. Bad time to be stuck with 400-ounce bars, I guess.

Because of the differences between the two contract specifications and the unique circumstances arising from Covid-19, an arbitrage opportunity arose. If you could get your hands on 100-ounce gold bars, you could capture what turned out to be free money. Naturally, this free money opportunity didn’t last very long – the jaws eventually snapped shut. In fact, the story is only interesting because the global market for gold is otherwise highly efficient. Liquidity is good, bid/ask spreads are narrow, and opportunities for arbitrage are rare. COMEX and LBMA have since made moves to avoid a reoccurrence of this unusual event, thereby making the market for gold even more efficient – the natural result of such market dislocations.

In a perfectly efficient economy, there would be no arbitrage. The same stuff would sell for the same price everywhere. In the real world, opportunities for arbitrage are ubiquitous. As economists know, arbitrage is one of the main drivers of increasing efficiency in the economy. If a shortage of supply in one area drives prices higher, arbitrageurs with access to lower cost supply in a different area will simultaneously buy and sell in both and capture the spread, thereby facilitating resupply in the area that needs it.

Incidentally, this is what makes accusations of price gouging during emergencies so counterproductive. If a hurricane knocks out power and local hardware stores experience a run on generators, the local price of generators should be allowed to rise substantially. If the local price of generators were allowed to double or triple, all manner of supply would quickly rush into the area. Instead, our political leaders pass laws to make such price discovery illegal, and in so doing they exacerbate the problem, extend the emergency, increase suffering, and reduce economic efficiency. But hey, at least it feels fair.

Trading tiny arbitrage situations in financial markets is a huge industry – many hedge funds specialize in making such bets, usually with lots of leverage. The simple idea of selling a slightly expensive security short while going long a substantially similar but cheaper security usually works well, but it is not without risk. Arbitrage spreads can widen beyond historical norms, making the short side of the trade awfully painful. In extreme situations, hedge funds have been put out of business because of bad arbitrage bets using too much leverage. It is a difficult game, and not one for amateurs.

Another approach is to focus on big arbitrage situations, and to only play one side of the trade. While the 6% price divergence in the gold market between COMEX and LBMA was historic, it pales in comparison to spreads often found in other commodities. If larger arbitrage opportunities are common in a market, that market must not be very efficient. Understanding the source of such inefficiencies, how extreme dislocations will likely resolve, and the safest way to play them can lead to substantial opportunities for excess returns, even for average investors (and average chickens).

Take coking coal, for example. As we wrote last week, coking coal isn’t burned to produce power. Instead, it is a key input into the production of steel. It has no substitutes. In many ways, the market for coking coal is beautiful in its simplicity. There are only so many steel mills in the world, and they are all knowable. There are only so many coking coal mines in the world, and they are all knowable. The cargo ships that move coking coal between producers and consumers in the seaborne market can be monitored using readily accessible and affordable online satellite tracking services. In other words, with enough sweat equity you can gain a comprehensive understanding of the entire market.

China is an extremely large producer of coking coal, but it is an even larger consumer. To meet the entirety of the country’s needs, it must import the difference. Australia is also a large producer of coking coal, much of it for export.  This natural marriage worked well for many years, until Covid-19 hit. Much to China’s outrage, Australia was vocal in its calls for a full investigation into the origins of the virus, including whether it may have leaked from a laboratory in Wuhan. In October of 2020, China responded with an unprecedented move and banned all imports of thermal and coking coal from Australia:

“State-owned utilities and steel mills in China received verbal notice from China's customs to stop importing Australian thermal and coking coal with immediate effect, several sources close to the matter told S&P Global Platts Oct. 9.

State-owned utilities including Huaneng Power International, Datang International Power Generation Company, Huadian Power International and Zhejiang Electric Power Co Ltd were heard to have received the verbal notice from China's customs, sources said.”

At first, market participants weren’t sure how serious China was or how long the dispute would last. It seemed like a drastic overreaction, one that would surely hurt China as much as Australia. As it became clear that China was deadly serious and that the dispute would drag on for many months, huge price disparities opened in the coking coal market. Throughout 2021, the cost of coking coal in China soared, while the price of seaborne coking coal from Australia sank. By mid-May, coking coal in China was trading hands for $320 per tonne, whereas Australian coking coal was priced at $130 per tonne, for a 150% difference. Now that’s an arbitrage spread!

Mix in the energy crisis and some weather issues, and the cost of coking coal in China exploded to unimaginable heights, approaching nearly $600 per tonne last month.

Eventually, the spread collapsed, and Australian coking coal tripled off its lows, equalizing with the price in China.

So, how might an observant chicken turn coking coal into gold? A straightforward approach is to go long producers who can work to close the arbitrage. While not a pure play on coking coal, Teck Resources (NYSE: TECK) is a large player in the seaborne market (disclosure: while we’ve traded Teck in the past, we currently have no position). It also has substantial zinc, copper, and oil sands operations, along with a solid balance sheet. Sure enough, Teck has filled a good chunk of the supply gap in China since the ban on Australian imports was implemented, and its stock has more than doubled.

Teck just turned in an impressive third quarter, generating more than $1.6 billion of adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA), driven in large part by its coking coal business. Teck’s current market capitalization is roughly $15 billion.  Here is CEO Don Lindsay giving some color on the industry dynamics during the company’s quarterly earnings call (emphasis added):

“Our steelmaking coal business unit had a strong third quarter, reflecting prices that are at unprecedented levels and a 16% increase in sales volumes relative to Q3 last year. Sales were 5.9 million tonnes, in line with guidance, including approximately 1.9 million tonnes of sales to customers in China, that are priced at premium CFR China prices, which increased to USD402 per tonne from USD257 in the second quarter, and we exited the third quarter at a record high of USD602 per tonne. And as I said earlier, today's prices are even higher.

The remainder, roughly 70% of our sales was sold based on the FOB Australia price, which averaged USD263 per tonne compared with USD137 in the second quarter. And we hit a record price above USD400 per tonne in late September. Given strong commodity prices, we maximize the utilization of available processing capacity to meet additional sales opportunities into China, while also completing a substantial proportion of our maintenance outages for the year during the quarter. So that sets up really well for Q4.”

A far more speculative (and therefore risky) pure play on coking coal is a company called Colonial Coal International (TSX: CAD, **see Disclaimer). Colonial is nothing more than a significant coking coal deposit in British Columbia in search of a buyer. It has no revenue and minimal expenses. Here’s how they describe themselves:

“Based in Vancouver, British Columbia, Colonial Coal International Corp. (CCIC) is a publicly traded pure-play metallurgical coal development company. Currently, CCIC holds a 100% interest in two resource-stage coal properties in the Peace River Coalfield of northeastern British Columbia, Canada: namely, the Huguenot and Flatbed properties. NI 43-101 compliant resources totalling approximately 189 million tonnes of combined Measured & Indicated resources plus 194 million tonnes of Inferred resources of hard coking coal have been estimated for main deposit at Huguenot. NI 43-101 compliant resources totalling approximately 298 million tonnes of Inferred metallurgical coal resources have been delineated at Flatbed.”

The math on Colonial is straightforward. With a total of 681 million tonnes of measured/indicated/inferred resources and 174 million shares outstanding, each share buys you roughly 4 tonnes of deposits. High quality deposits like this used to fetch $3 or more per tonne when acquired. It currently trades for a little over $2 a share in US dollars (roughly $0.50 a tonne), about double from where we bought it at the end of September.

Connecting the dots between the China-Australia stand-off and suppliers across the Pacific is where things get really interesting. As many readers will be aware, the relationship between Canada and China has not been without strain of late, especially after the detention of Meng Wanzhou, Huawei's chief financial officer. China responded by effectively holding two Canadian businessmen (Michael Kovrig and Michael Spavor) hostage on trumped up charges of spying. In late September, China and Canada cut a de facto prisoner exchange deal. Wanzhou was given a hero’s welcome upon her return to China, and Canadian Prime Minister Justin Trudeau was sure to pose for the cameras with the newly returned “Two Michaels” when they landed in Calgary.

The resolution of this standoff signals that Canada is open for business again in the eyes of the Chinese. China is one of a few natural buyers for Colonial and recent events signal that the relationship was warming. China has a strong track record of securing supply of key resources in other geographies – might Colonial be on the list?

One can only speculate, but it fits the pattern. Now, it could take years for a transaction to occur, the price of that transaction could be less than the current share price, and government intervention is an ever-present risk. But if an international standoff caused this arbitrage to begin with, surely the resolution of another opens up some possibilities. Sure enough, you can spot on the Colonial chart when the prisoner swap occurred.

Next up? Natural gas…

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**DISCLAIMER: MEMBERS OF THE DOOMBERG TEAM ARE LONG SHARES OF COLONIAL COAL INTERNATIONAL CORPORATION. THEY MAY ADD, REDUCE OR CLOSE THEIR POSITION AT ANY TIME. NOTHING PUBLISHED BY DOOMBERG SHOULD BE CONSIDERED INVESTMENT ADVICE. SEEK PROFESSIONAL FINANCIAL ASSISTANCE BEFORE MAKING INVESTMENT DECISIONS. SEEK PROFESSIONAL MENTAL ASSISTANCE IF YOU LOOK TO A GREEN CHICKEN ON SUBSTACK FOR TRADING ADVICE. WE WOULD ADVISE YOU TO FADE THE GREEN CHICKEN AS A CONTRA INDICATOR, BUT THAT WOULD BE INVESTMENT ADVICE, SO WE WON’T (BUT YOU SHOULD CONSIDER IT).