Shoemaker's Children
“Don't worry about the world coming to an end today. It is already tomorrow in Australia.” – Charles Schulz
On rare occasions, markets clear at prices previously believed to be impossible. Of course, the word impossible is a slight exaggeration, but few people thought interest rates on government bonds could sustainably go negative, used car prices could exceed those of new cars, and oil could trade for minus $37 a barrel. Until they did.
Introspection of such events post facto is a great way to learn something new about otherwise well-understood instruments. For example, in the oil market we learned that if you can’t actually take delivery of a commodity, and you hold a soon-to-expire contract without a cash settlement option, you might need to pay someone who can stand for delivery to take that contract off your hands. We also learned the severity of the impact of our response to Covid-19 on supply chains, the repercussions of which are still being dealt with more than two years later.
An interesting tactic of lateral thinking is to ponder what would make the impossible possible before it materializes to prod whether you can preemptively learn something new before you stub your toe on it. For example, under what scenarios could a stock trade for negative prices? That certainly seems impossible. But what if the government made it illegal for most members of society to hold ownership in the stock of a specific company – a Russian energy producer, for example? Might current owners pay the select few who can legally take possession to accept their certificates to avoid running afoul of the law? Alternatively, what if bankruptcy laws were changed such that equity owners could no longer discharge debt in a restructuring and simply walk away with no residual liabilities? Do negative stock prices seem so impossible now?
It is in this spirit that recent action in a relatively off-the-radar corner of the coal market caught our attention and made us ponder what our trusty Bloomberg terminal was telling us. For the first time that we can recall, the price of thermal coal has now decisively exceeded that of coking coal for several weeks, a bizarre situation few would have predicted. Thermal coal is burned to produce electricity, whereas coking coal is a higher quality product used exclusively to make steel. As the US Energy Information Administration (EIA) describes it, “Coking coal must be low in sulfur and requires more thorough cleaning than coal used in power plants, which makes the coal more expensive.”
Yet, here we are:
Although we have written about coking coal before and have a decent understanding of its market dynamics, this situation admittedly leaves us a little puzzled. We assume coking coal is a fine (superior?) starting material to make electricity, and that this unique arbitrage will soon be closed as procurement teams at electricity producers develop relationships with the salespeople at coking coal producers. But is there something deeper to be learned here? At first glance, the price chart signals that the near-term shortage of electricity inputs is extreme, and the need for steel is waning – both developments that could foreshadow future economic dislocations. However, those benchmark prices are both tied to Australia which, as the largest exporter of coal in the world, should be well-suited to weather the energy storm. And yet, quite the opposite is occurring. Let’s dive in.