A global seaborne steam coal market split between the Atlantic and Pacific basins has been complemented by a thriving financial derivatives market, which itself has witnessed exponential growth since its inception in the late 1990s. 

Around 1.3 billion metric tons of coal derivatives traded in 2006 while an estimated 2 billion mt traded in 2007. 

In short, the derivatives or 'paper' market has brought flexibility to participants. 

Producers and end-users can now hedge their coal sales and purchases against adverse price movements, while speculative players such as banks and hedge funds have been able to join the party, as trading derivatives means they are not saddled with the logistical complications of taking physical delivery of coal. 

The biggest coal derivatives market is API2 (All Published Index number 2), for CIF ARA (Amsterdam, Rotterdam and Antwerp) coal, delivered into Europe and inclusive of freight costs and insuarance, which traded over 900 million metric tons in 2006. 

API4, for South African free on board (FOB) coal is the second largest market, trading around 400 million mt in 2006. 

The globalCOAL FOB Newc market, for Australian coal, is the most recent to emerge, and while only accounting for around 5% of the total derivatives market, it is growing year-on-year. 

What kind of derivative product is trading in coal? 

The derivatives in question are over-the-counter (OTC) swaps, so-called because they are effectively an exchange of fixed and floating cash payments between two counterparties and settled against either the API2, API4 or globalCOAL FOB NEWC indices. 

They are quite versatile instruments as price, quantity traded, the period over which the deal is made and the basis on which it is priced are all open to negotiation between the two counterparties. 

The API2 index, which is an estimate of the current 90-day price for steam coal delivered into Europe, and the API4 index, are calculated by various publishers. 

The FOB Newc index is based on actual deals, bids and offers registered on the globalCOAL trading screen for the underlying physical Newcastle coal product. 

Platts Forward Curve - Coal is a daily assessed forward curve for the API2, API4 and Newcastle markets with prices going back to May 2007. 

One common misconception is that a forward curve is a set of forecast prices, which is absolutely not the case. 

Studies have shown that it's not a good predictor of future spot prices. It is actually a curve (see chart), representing the prices at which the market is willing to transact future business today. 

For example, a utility may need to buy coal in the fourth quarter of 2008. It can buy a Q4 swap on the derivatives market so if the price of coal on the spot market should increase from now until Q4, the swap it has bought will increase in value. 

The profit made from selling the swap and closing the position acts as a kind of insurance policy against the rising physical price. 

This practice is known as hedging and generally allows coal buyers and seller to fix a price on their transactions and protect themselves from price volatility. 

Of course, a large portion of the coal paper market comprises of purely speculative players such as banks and hedge funds, while the other market participants will not just limit themselves to hedging and will take on speculative positions as well. 

Global supply disruptions in major coal exporting countries such as Australia, Indonesia, China and South Africa have contributed to soaring FOB and freight costs, which in turn have caused coal swap prices to double over the last 12 months (see chart). 

Bullish sentiment increases liquidity and the coal market has been no exception. 

Anyone taking a long position in any of the API2, API4 or Newcastle markets last year will have made a tidy profit, and with further volatility predicted, traders will be keen to take advantage of the many arbitrage opportunities that are likely to present themselves. 

As coal swaps volumes continue to grow and the once-fledgling market matures, questions still remain over its future development. 

Some potential market players say they are itching to get their teeth into the market, but cannot trade OTC swaps due to credit issues.