Japan's annual coal contracts face uncertain future

Japan's annual supply agreements, which run from April, the start of the country's financial year, remain one of the most important events in the thermal coal calendar.

But trying to pick a winner from this year's negotiations is not straightforward.

Is it the Japanese utilities, which saw their call bill fall by 17 per cent compared with last year, or Rio Tinto, which outmanoeuvred its bigger coal rival Glencore in signing the first agreement?

That deal, struck at $67.80 a tonne, was the lowest in eight years but the fall in the Australian dollar means the miners are getting slightly more than last year's contract.

Moreover, looking at what the Japanese are to pay over the spot and futures price, the premium of almost $10 a tonne "is bigger than any point over the past 15 years", says Macquarie analyst Stefan Ljubisavljevic, even though the market is oversupplied.

"Over the past six years, the contract has been set at an average premium of $7 a tonne and $4 to spot and the forward market, respectively. This year's settlement substantially exceeds these levels," says Mr Ljubisavljevic, noting the premium to the year-ahead futures price is particularly stark at almost $15 a tonne.

But for all the frisson around this year's negotiations, there is a sense in the coal market that the importance of this annual ritual its gradually waning.

The Japanese are among the world's biggest consumers of seaborne thermal coal, used to generate electricity.

The April settlement is used by other Japanese utilities and Australian miners, their suppliers of choice, to price their deals. They also acted as a reference price for contracts across the Asia-Pacific region.

The April-March contracts have historically accounted for about half of Japan's annual coal imports of 140m tonnes. However, that figure has fallen in recent years as some Japanese buyers have switched to quarterly supply agreements and shorter-term deals that reference indices such as GlobalCoal NEWC.

The changes come against a backdrop of oversupply and weak prices - coal shipped from the Australian port of Newcastle has dropped 30 per cent in the past year to $58 a tonne - that has made thermal coal a buyers' market.

Even the Japanese, who revere tradition, and more importantly understand the need to secure high-quality Australian coal for their boilers, realise they are in a stronger negotiation position and in a falling market may not necessarily fix all their needs through longer-term contracts.

Ted O'Brien, chief executive at coal research firm Doyle Trading Consultants, says: "The Japanese are cognisant of the quality needs but they will not pay a price above what they think the market is worth just to lock in their volumes."

This situation is expected to continue until the glut is cleared and the market balances itself. This could take several years as the producer reaction to the fall in prices has been relatively slow because of lower oil prices and falling commodity currencies. The Australian dollar, for example, has fallen 20 per cent in the past year against the US currency.

"There is too much capacity in the market. The fall in prices has not resulted in rationalisation so far," says Andy Roberts, director of international thermal coal at Wood Mackenzie. "We think it will be five-six years before you see any turnround."

It is still not clear how many tonnes will reference this year's first deal between Rio and Tohoku Electric. Talk in the market is that it could be around 10m-20m tonnes, according to traders and analysts.

Apart from sluggish prices, structural changes in the coal market are also eroding the importance of the April negotiations.

Contractual tonnage is still the main method of pricing coal into Japan, South Korea and Taiwan. But for Chinese buyers, spot market transactions have become more commonplace over the past couple of years, says Matthew Boyle, analyst at consultants CRU.

That is also reflected in the rising volumes of swaps on the open market as buyers use derivatives to hedge their physical coal exposures. Data from Intercontinental Exchange show the volume of the Newcastle futures market represents 230m tonnes in 2014, up from 112m in 2011. In the first three months of this year, volumes stand at almost 90m tonnes.

The volumes are still modest but are increasing steadily, says Carlos Fernandez Alvarez, senior coal analyst at the International Energy Agency.

Most market participants agree the benchmark is not going to disappear immediately as the Japanese utilities will need to feel some security in their coal supplies. The "nuclear phobia" that has gripped Japan since the Fukushima earthquake means that most nuclear power plants are unlikely to come back online soon.

Nevertheless, another factor that will further push the Japanese utilities to spot or shorter contracts is the liberalisation of the retail electricity market in 2016. It is unclear how much immediate competition in retail prices there will be, but Japanese traders say it would be politically unacceptable for utilities to be seen to be buying coal at the same benchmark price.

On a practical level, once full liberalisation starts, utilities will need to compete by looking for low procurement costs. One way to do that would be to buy less on annual contracts.

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