of gasoline, naphtha, and kerosene fractions and can be blended with crude oils.
Natural gas markets are much more localized than other energy markets and multiple pricing methods prevail globally; this has allowed only a few benchmark prices to attract sufficient market liquidity. The benchmarks that have gained popularity include Henry Hub Natural Gas in the USA, the National Balancing Point (NBP) in the UK, and Zeebrugge and TTF (Title Transfer Facility) in Continental Europe.
Coal
Coal is a black or dark-brown combustible sedimentary rock that is formed by the carbonization of vegetation and is composed primarily of carbon, along with varying proportions of hydrogen, nitrogen, sulfur, and oxygen. It generally occurs in rock strata, in layers called coal beds or coal seams. There are various grades of coal, classified based on the amount of time spent under intense heat and pressure, which affects their chemical properties. Lower-rank coals such as peat, lignite, and sub-bituminous coals have lower amounts of carbon by weight and are more volatile. Higher-rank coals include anthracite and bituminous coal, which have higher carbon and, thus, higher heat content.
Anthracite coal is primarily used for heating. Bituminous coal can be divided into two types – thermal or “steam coal” and metallurgical or “coking coal.” Steam coal is mainly used for power generation and as an energy source for cement production, while coking coal is used to produce coke, which acts as a reducing agent in the production of pig iron and subsequently, steel. Lignite and sub-bituminous coals are mainly used for power generation. Coal can be converted into liquids to use as alternate fuels for transport, cooking, power generation, and in the chemicals industry. Coal can also be converted to syngas, a mixture of carbon monoxide and hydrogen gas, and subsequently used to produce electricity or other transport fuels.
Global coal markets can be split into two major regions – the Pacific basin and the Atlantic basin. The major benchmarks for thermal coal are based on delivery at ports where coal is exported from or imported to, and include Newcastle coal (Australia), API4 coal (Richards Bay, South Africa), and API2 coal (Amsterdam Rotterdam Antwerp, ARA). Further, local coal markets like the USA have their own benchmarks.
PRICE DRIVERS IN ENERGY MARKETS
Prices in physical markets are influenced by a myriad of factors. As in most markets, supply and demand play a major role in price determination. Commodity prices are also generally linked to economic performance, with growing economies consuming more commodities, and thus raising prices. Commodity prices are also influenced by events affecting the supply chain of the product, from producers and refiners to distributors and consumers.
As a number of energy commodities are considered strategic assets and their production is concentrated in the hands of a few countries, which are largely emerging economies that can be prone to instability, there is a geopolitical aspect to price determination as well. As commodities get increasingly financialized, with major financial players like banks and hedge funds trading in these markets, commodity prices have also become linked to other asset prices.
Let us examine some of these factors briefly, using the oil markets as an example.
Geopolitical Risks
Oil prices are particularly vulnerable to events such as war, internal strife, or terrorist attacks, especially in the sensitive Middle East region. For example, oil prices spiked in the wake of the Gulf War and the Iraq War of 2003, as well as during the “Arab spring” rebellions across a number of countries in North Africa and the Middle East. In such environments, oil prices trade at a premium to prices implied by supply/demand balance, and this is sometimes dubbed the “fear premium.” In contrast, resource nationalism, in the form of higher royalties or outright nationalization of assets, has been decreasing in recent years and many national oil companies are opening up to collaboration with global oil companies due to the scarcity of capital and technological know-how needed to exploit new reserves.
The Geopolitical Chessboard – The Petrodollar System and Rising China
Earlier in this chapter we discussed the strategic role played by energy resources and touched on how the pricing of this commodity can impact the destiny of large nations. The fact that more than 60 % of the global production of oil moves on maritime routes makes naval power integral to securing the supply of oil and thereby shaping the world's geopolitical chessboard. By far, the USA is the mightiest naval power in the world and has been successful in providing protection to major oil producers and securing the maritime routes, thereby deserving the privileges of the petrodollar system. Other rising powers, like China, have also relied on US-led maritime route security to secure the energy imports required to build an industrial complex and accelerate their economic growth. However, it is only recently that these nations have begun viewing these energy maritime routes as the source of vulnerability that they are and have taken steps to address these weaknesses and reduce their exposure to the petrodollar system.
The Strait of Hormuz, the Strait of Malacca, the Suez Canal, Bab El Mandab, the Danish Straits, the Bosporus and, to a lesser extent, the Panama Straits are the major oil chokepoints, representing the most strategic locations that have shaped the geopolitics of the last 40 years. The most strategic and troubled chokepoint remains the Strait of Hormuz, which has been used as a bargaining card by Iran to negotiate with the West and put pressure on neighboring oil-producing countries.
In the case of China, the world's second-largest oil-consuming nation, the situation is much more complicated, because its oil imports need to move through two major chokepoints and a troubled South China Sea, as shown in Figure 1.4.
FIGURE 1.4 Oil maritime routes and chokepoints
Data Sources: US Energy Information Administration analysis based on Lloyd's List Intelligence, Eastern Bloc Research, Suez Canal Authority, and UNCTAD, using EIA conversion factors. Estimates are for year 2013.
China imports over 70 % of its crude oil from the Middle East and the traditional sea route has been through the Indian Ocean, the Strait of Malacca, and the South China Sea. China remains concerned about its security of sea lanes, especially those passing through the Strait of Malacca and the South China Sea, through which an estimated 80 % of its oil imports transit. Also, in the absence of a significant global naval presence, China is not comfortable relying on oil imports passing through the South China Sea, which is surrounded by countries that are perceived to be part of a US-led containment coalition. These potentially hostile countries include the Philippines, Japan, and Taiwan, which were once referred to as an “unsinkable aircraft carrier” by General MacArthur. As a nation that is not a US ally, China fears the disruption of its oil imports in the case of hostilities in the region.
In order to alleviate the disruption risks, China has done a formidable job developing trade links with its Central Asian neighbors and building infrastructure in close South Asian neighbors to gain access to the Indian Ocean. Together with Pakistan, China has been developing a megaproject called the China Pakistan Economic Corridor (CPEC) consisting of a network of highways, railways, and oil and gas pipelines over 3000 km running from the port of Gwadar all the way to Kashgar in China. The CPEC will give China access to the Arabian Sea not far from the Strait of Hormuz. Similarly, China gained access to the Bay of Bengal via Sino-Burma pipelines, which transport oil and gas from the port of Kyaukphyu to Kunming (Yunnan Province). In addition to cutting the shipping time of Middle Eastern and African crude oil significantly, these two shortcuts are game-changers on the chessboard as they help avoid crowded South China Sea waters and any unexpected hostilities in transit. Additionally, as mentioned earlier, China has also been working closely with its neighbors in the east and the north, signing megaprojects allowing Russia to trade its oil and gas in Yuan or Roubles using trade-offset mechanisms to minimize its dependence on the US dollar and related unpredictability in financing costs.
Oil prices are particularly vulnerable to events such as war, internal strife, or terrorist attacks, especially in the sensitive Middle