API 2 options activity reveals weak market sentiment
A burst of API 2 options activity during the latest upswing in coal prices reveals an increasingly cautious outlook, raising the prospect that recent gains could soon be unwound.
The API 2 calendar 2021 coal swap climbed to a five-month high of $59.20/t on 7 July, but had eased to $57.75/t on 10 July. The contract had gained $7.35/t, or 14.2pc, since reaching a record low of $51.85/t on 29 May, which was the strongest 27-day period for an API 2 year-ahead contract since July 2019.
The rally in forward prices has come despite the persistently weak demand outlook in Europe. The market broke technical resistance levels in June after supply disruption in Murmansk jolted the spot market higher, and wider strength in energy commodities led by a surge in carbon prices and a gradual recovery in oil has helped to sustain the trend into a second month.
But recent options activity betrays increasingly weak sentiment. Open interest in year-ahead API 2 options handled by the Intercontinental Exchange (Ice) has risen by 57pc since the start of June to 22.9mn t, exchange data show, with around 54pc of the increase driven by new positions on right-to-sell put options.
The most popular strikes for new put positions in recent weeks have been $50/t, $52/t and $40/t, which are currently out of the money and insuring the holder against respective losses of more than $7.75/t, $5.75, and $17.75/t on the year-ahead, based on the contract's $57.75/t settlement on 10 July.
And implied volatility data published by Ice now show a reverse skew, suggesting options at lower strikes — out-of-the money puts and in-the-money calls — are valued higher than options at higher strikes. This contrasts with the end of May, when implied volatility on year-ahead options was skewed forward, suggesting greater value for options at higher strikes (see chart).
But while options activity has increased in recent weeks, there are now fewer open positions on strikes at the money or in the money than in late May. As of 9 July, the biggest open interest for in-the-money put options was 75 lots on $60/t strikes, with a total of 185 lots — 2.2mn t — profitable at strikes as high as $71/t. This is down from 235 lots of in-the-money put options at the end of May.
Only 30 lots of year-ahead call options — 15 lots at $54.50/t and 15 at $57.50/t — were in the money as of 9 July, up from zero at the end of May.
The most popular year-ahead option is currently the $50/t strike put, which may create a level of support for the API 2 year-ahead in the run-up to options expiry in early December.
Fundamentals still weak
Open interest on API 2 forward contracts has slumped during the latest rally in prices, despite growing options liquidity. This means more positions have been closed than opened in recent weeks and suggests traders are unconvinced by the latest upward trend.
The year-ahead demand outlook for coal in Europe remains weak and has actually softened in June and July, as firmer fuel and carbon costs have eroded clean dark spreads. The expected margin for a 46pc-efficient coal-fired plant for year-ahead base-load generation slumped to a record low of €4.56/MWh on 10 July, down from nearly €6.50/MWh on 22 June.
At current prices, around 53pc of German coal-fired capacity faces negative year-ahead generation margins, compared with around 19pc of the fleet this time last year, with all units struggling to price competitively against gas. This is likely to mean diminished demand among utilities on the API 2 year-ahead for hedging purposes.
At the same time, recent strength in prices has created an opportunity for producers to sell forward on the curve to hedge their 2021 supply, which may compound weak sentiment in API 2 swaps in the near term.
And technical signals, which strengthened in June, are also showing signs of weakness. The moving-average convergence/divergence indicator surged in May and June, but was on the verge of crossing back below the signal line at close on 10 July for the first time since 6 May.
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