London: Indian and Chinese coal traders face big losses if they fail to ramp up their use of derivative instruments to hedge a growing shipping freight exposure.

Indian traders who have not hedged either coal or freight costs are likely to fail to honour contracts, creating a domino effect of losses for their suppliers, said traders and producers who declined to be named. This will result in a rash of disputes and lawsuits, they said, as has happened several times during the past few years.

Freight rates have remained erratic in recent months partly due to bursts of coal and iron ore buying activity by China and depressed demand for raw materials due to the economic downturn.

“If you have volatility in the freight market, that has repercussions further down on the supply chain," Nikos Nomikos, reader in shipping risk management with London’s Cass Business School, said.

Coal prices have also risen to a 12-month high this month due to strong demand from China and India.

Indian coal traders, who supply almost all the 20 million tonnes (mt) of South African coal imported annually into the country, are currently losing up to $10 a tonne by not hedging coal linked to the benchmark API4 physical price index. Traders say importers have also not hedged their coal freight, with many companies facing massive losses and closure. “We have lost in a month what we made in a year," an Indian trader said, declining to be named.

Some Indian traders say they may push counterparties to re-negotiate coal contracts at lower fixed prices to mitigate losses.

The 400 mt Asian physical coal trade is double that of the Atlantic market where traders hedge every tonne. Only a small part of coal price risk in Asia is hedged using swaps with even less done via freight forward agreements (FFAs).

FFAs allow a buyer to take a position over where freight rates will stand at a point in the future and are the commonly used instrument to hedge freight risks.

Most FFA contracts are settled against the Baltic Exchange’s physical indices.

“Any serious coal market player who isn’t hedging his freight either through contracts or through taking in tonnage or through the freight derivatives market would seem to be running a significant and unnecessary risk," Baltic Exchange chief executive Jeremy Penn said.

Indian traders said they find FFAs costly and not entirely appropriate to their needs.

“The FFA market is not popular with the Indian market," another Indian coal trader said. “FFAs are difficult to use and expensive."

FFA shipping routes do not include the routes most used by Indian players to a variety of Indian ports from South Africa’s Richards Bay. This means several FFA routes are needed to hedge.

Clive Murray, chief executive of London Commodity Brokers (LCB), said FFA market players were reluctant to accept Indian counterparties, making clearing more necessary than ever to reduce risk.

“The FFA market has a long way to go yet before it will be able to accept Indian exposure," he said.

Murray said exchange controls in China and India have made it difficult to use derivatives.

“The authorities in these countries need to have it proved to them that the use of derivatives is purely for hedging and not for speculating, which makes it complicated," he said.