USE OF INDICES AND RISK MANAGEMENT TOOLS FOR

KALIMANTAN COAL

PREPARED FOR:

3RD ANNUAL KALIMANTAN COAL PREPARED BY:

ERLEND ENGELSTAD SENIOR RESEARCH ANALYST BASIC RESOURCES RESEARCH GROUP

BALIKPAPAN, INDONESIA 3RD SEPTEMBER 2014

2

• Pioneers in coal derivatives and physical coal brokerage

• Hybrid execution facility for coal derivatives

• Multilingual specialist team arranging physical coal transactions

• Reputable research desk providing insight across the energy complex

• Global coverage from offices in Europe, Asia and the US

• Awarded #1 Inter-Dealer Broker in Coal by SGX in 2013

• Awarded Research House of the Year by Energy Risk in 2014

About Marex Spectron

• One of the world's largest privately owned brokers of financial products in the commodities sector and a leader in brokering physical energy products.

• Significant market share in the energy, metals, freight, environmental and agricultural markets – both on-exchange and over-the-counter. We are also a premier specialist broker of financial futures, foreign exchange and securities.

• We are a major provider of market information products – research, analytical reports, live market screens and price feeds

• Marex Spectron currently employs around 600 people, with the group’s global headquarters in London and offices across Europe, Asia and USA.

Marex Spectron and Coal

3

4wk annualized volatility – Indonesia Sub-bit

• Volatility is an central measure of risk, and can be expressed in terms of probabilities (i.e. VaR) or in $ scenarios as below.

• Although volatility in coal markets is at relatively low levels compared to 2008 (with spikes above 150%), prices are extremely sensitive to short term supply/demand tightening.

• Short term volatility can rise significantly on;

• Short term tonnage supply squeeze in the dry bulk fleet.

• Cyclical weather patterns impacting infrastructure and production.

• Geopolitical uncertainty (i.e. Ukraine).

• Environmental and protectionist measures from governments.

• When is hedging not necessary? • If you know for certain where the price will go. • If you can pass along your costs to end users.

Return distributions (weekly)

The Case for Hedging

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

$0

$20

$40

$60

$80

$100

$120

Aug08 Aug09 Aug10 Aug11 Aug12 Aug13 Aug14

4wk annualized volatility Indonesian Sub-bit (4,900)

0

5

10

15

20

25

30

35

40

-5.0

%

-4.5

%

-4.0

%

-3.5

%

-3.0

%

-2.5

%

-2.0

%

-1.5

%

-1.0

%

-0.5

%

0.0

%

0.5

%

1.0

%

1.5

%

2.0

%

2.5

%

3.0

%

3.5

%

4.0

%

4.5

%

5.0

%

Mo

re

Nu

mb

er

of

ob

serv

ati

on

s

Newcastle 6000 Indonesia sub-bit

Sensitivities 4900 NAR @ $53.40 (15 Aug 2014)

30000

50000

70000

90000110000130000

$-

$200,000

$400,000

$600,000

$800,000

$- - $200,000 $200,000 - $400,000 $400,000 - $600,000 $600,000 - $800,000

Source: IHS McCloskey, Marex Spectron Research

Source: IHS McCloskey, Marex Spectron Research Source: IHS McCloskey, Marex Spectron Research

4

• Derivatives such as swaps, futures and options are contingent claims on future cash flows from a counterparty (either a company, or a clearing house)

• The value of the claim (which may also be negative) is dependent on the movement of an underlying instrument

• The concept of commoditization stems from several underlying assumptions;

• You have a tangible cash flow in the underlying market (exposure)

• Your product is easily replaceable in the marketplace (substitutability)

• There are many buyers/sellers of your product (liquidity)

• Facilities for credit and clearing are available (financing + counterparty risk)

• Volatility = uncertainty in gains/losses; and leads to

• Unpredictable earnings

• Potential squeeze on profit margins

• Tighter credit lines with banks

• Shorter tenures and stricter payment terms

• Potential agency problems

Exposures with 0%, 50% and 100% hedge in place for Q1 2014

Commoditization and hedging

$57

$58

$59

$60

$61

$62

$63

Dec13

Jan

14

Fe

b14

Ma

r14

Ap

r14

Ma

y14

INDO 100% hedged @62 50% hedged @62

Source: Marex Spectron Research

HEDGING IS THE TRANSFER OF RISK BY TAKING AN OPPOSITE AND OFFSETTING POSITION IN AN EQUIVALENT PRODUCT

1) DIRECTION

Am I long, short or neutral the underlying?

2) PERIOD

Which swaps contract period matches my

physical exposure?

LONG (buy) Pay fixed

Receive floating

Gains value if market > swap price

SHORT (sell) Pay floating

Receive fixed

Gains value if market (spot) price <

swap price

TWO INITIAL POSITIONS FOR A SWAP:

3) VOLUME

Am I hedging 100% of my underlying exposure

Am I using a proxy?

4) TRADING OUT

When should I unwind my position?

CONSIDERATIONS BEFORE PLACING A HEDGE:

Go long costs & short revenue

6

Unstable ratios affecting calculation of hedging volume

• Basis risk is the mismatch between properties in physical trading vs the assumptions made in index production, i.e.:

• Bespoke contract idiosyncrasies (premiums/discounts)

• Breakdown in a priori assumptions (covariance, hedge ratio)

• Delivery locations outside the index scope

• Rule of thumb;

• If you’re short the market, you are long the basis (and vice versa)

• Monitor magnitude of changes between spot and futures market

• Prudent surveillance of portfolio risks

• Exchange for Physical (EFP); simultaneous sale of physical cargo while buying a futures contract – links performance & price

Benchmarking Indonesian Coal

Basis Risk

60%

65%

70%

75%

80%

85%

Aug12 Nov12 Feb13 May13 Aug13 Nov13 Feb14 May14 Aug14

Indo 4900 vs Newc Indo 4900 vs Indo hi-bit (basis 6000)

30 31 32 33 34 35

China India Korea Taiwan

Pricing power FOB Indonesia

$55

$65

$75

$85

$95

$105

$115

$125

$135

HBA NEWC Sub-bit basis NEWC

Source: IHS McCloskey, Marex Spectron Research

Source: IHS McCloskey, Marex Spectron Research Source: Marex Spectron Research

7

Correlations – Argus/McCloskey Indonesia indices

• Choosing an index product for hedging a cargo;

• Does it represent price changes in my underlying exposure (direction and magnitude)?

• Does it reflect the quality of my cargo? Can nonlinear properties be objectively quantified? (i.e. Platts’ ash discount)

• Is the granularity of assessments sufficient to avoid timing risk?

• The only liquid instrument that exclusively accounts for Indonesian coal price movements is the Argus/McCloskey Sub-Bituminous index;

• Published every Friday

• Assessed independently and anonymously through surveys,

trades weighted more than bids/offers

• Diverse participant distribution (25% producers, 25% end

users, 50% traders)

• Uses the FISTA contract ports and normalizes for freight

differentials

• Choosing an instrument; swaps, futures, EFRP, EFS, Blocks….?

• Effectively most of these are equivalent and/or fungible instruments in terms of their economics and execution

• Some differences occur in terms of regulations, time windows, margin requirements and reporting conventions

• Many regulations are still pending approvals, harmonization and implementation

• In the coal market, most participants refer to SWAPS (although contract is a future)

Newcastle 6000 versus Indonesia sub-bit (4900 NAR)

The case for hedging

Indo Sub

Sub-bit

(3,800 GAR)

Indo Sub

Sub-bit

(4,200 GAR)

Indonesian

Sub-bit

(4,900)

Indo

Mid-Bit

(5,500)

Indo

Mid-Bit

(6,000)

Indo Hi-

Bit

(>5,850)

Indo Sub

Sub-bit

(3,800 GAR) 100%

Indo Sub

Sub-bit

(4,200 GAR) 97% 100%

Indonesian

Sub-bit

(4,900) 76% 82% 100%

Indo Mid-Bit

(5,500) 64% 70% 93% 100%

Indo Mid-Bit

(6,000) 64% 70% 93% 100% 100%

Indo Hi-Bit

(>5,850) 52% 59% 82% 89% 89% 100%

$50

$55

$60

$65

$70

$75

$80

$85

$90

$95

$60 $70 $80 $90 $100 $110 $120 $130

Ind

o 4

900

Newcastle 6000

Source: IHS McCloskey, Marex Spectron Research

8

Global coal derivatives volumes 2000-2013 (million metric tonnes)

• Liquidity in coal derivatives in Asia Pacific increasing on the back of;

• Continued high demand for coal; concentrated supply

• Decrease in the use of long term pricing mechanisms; move towards spot market

• Liberalization of electricity markets (albeit work in progress)

• 9.43mill tonnes traded on Indonesia sub-bit index in 2013 – 2.5mill tonnes traded in Jul-14 alone

• 12mill tonnes traded on API8 in 2013 – expected to double in 2014

• With the Atlantic and Pacific basins becoming more disconnected from each other, market participants are increasingly looking for credible, liquid benchmarks for their Asian coal exposure

Liquidity in Indonesian Sub-Bit derivatives volumes

Liquidity in coal markets

-

500,000

1,000,000

1,500,000

2,000,000

2,500,000

3,000,000

Jan

11

Ma

r11

Ma

y11

Jul1

1

Se

p11

Nov11

Jan

12

Ma

r12

Ma

y12

Jul1

2

Se

p12

Nov12

Jan

13

Ma

r13

Ma

y13

Jul1

3

Se

p13

Nov13

Jan

14

Ma

r14

Ma

y14

Jul1

4

Sub-Bit Trend

500

1,000

1,500

2,000

2,500

3,000

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

API2 API4 Newc Indo API8 API5

Source: SGX, CME, ICE, Marex Spectron Research

Source: SGX, CME, ICE, Marex Spectron Research

9

• A clearing house is a central counterparty that significantly reduces (in effect, eliminates) the risk of default through good-faith deposits (collateral) and variation margins.

• In addition to the elimination of counterparty risk and cash flow management, The benefits of clearing are reduced capital requirements, margin offsets between related positions, and netting of portfolio returns.

• Margins are set on proprietary formulas where the main component is volatility, designed to account for assumed liquidation costs in case of default

• Major clearers for Indonesian coal derivatives are CME, SGX and ICE

Clearing & Other Instruments

INSTRUMENT DESCRIPTION INDEX PROVIDER QUALITY CLEARING PROVIDED?

API 4 FOB Richards Bay Argus / McCloskey 6,000kc NAR ICE, CME, SGX

API 2 CIF ARA Argus / McCloskey 6,000kc NAR ICE, CME

NEWC FOB Newcastle globalCOAL 6,000kc NAR ICE

API 8 CFR South China Argus / McCloskey 5,500kc NAR CME, SGX, ICE, HKEX

Indonesia Sub-Bit FOB Indonesia McCloskey 4,900kc NAR CME, SGX, ICE

API 5 FOB Australia Argus / McCloskey 5,500kc NAR CME, SGX Source: SGX, CME, ICE, Marex Spectron Research

FUNDAMENTAL DRIVERS IN THE COAL MARKET FOCUS ON ASIA PACIFIC

11

Price arbitrage vs. Imports (China)

Price arbitrage vs. Imports (India)

• All top 3 importers of thermal coal are either heavily dependent on the price arbitrage between domestic and imported coal (China and India) or the prices of natgas and CO2 emissions (EU)

• Chinese imports under pressure due to falling arb. Incentive

• Imports in to India were also weak for the bigger part of 1H 2014 due to sharp rupee devaluation in 2013 and aggressive pricing of domestic coal. Situation is gradually changing as Coal of India increased sharply the domestic price

• In the case of EU, wide open climate spreads was driving the surge of coal burn in 2012-2013. The spread is now closing…

Climate spread vs. Imports (EU27)

Medium-term drivers: Import arb

-$40

-$30

-$20

-$10

$0

$10

$20

$30

5.00

10.00

15.00

20.00

25.00

30.00

Jan11 Jun11 Nov11 Apr12 Sep12 Feb13 Jul13 Dec13 May14

Mln t Differential (rhs) Imports

0

2

4

6

8

10

12

14

16

18

20

-$20

-$15

-$10

-$5

$0

$5

$10

$15

$20

Jan11 May11 Sep11 Jan12 May12 Sep12 Jan13 May13 Sep13 Jan14 May14

Mln t/month Differential Imports

-10

-5

0

5

10

15

20

25

30

35

400

500

600

700

800

900

1000

1100

1200

1300

Jan11 May11 Sep11 Jan12 May12 Sep12 Jan13 May13 Sep13 Jan14 May14

Climate spread Coal burn

-$15

-$5

$5

$15

$25

$35

$45

Jan14 Feb14 Mar14 Apr14 May14 Jun14

IndonesiaAustralia

-$15

-$10

-$5

$0

$5

$10

$15

Jan14 Feb14 Mar14 Apr14 May14 Jun14

Russia

USA

S.Africa

Colombia

12

Medium-term S&D drivers: Trade flows shift

Atlantic: CIF ARA price >/< Average

Pacific: CIF China price >/< Domestic

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2012 2013 2014 2015

US

South Africa

Colombia

Russia

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2012 2013 2014 2015

Australia

Indonesia

Atlantic: Exports growth

Pacific: Exports growth

• The Asian trade has also declined but for different reasons

• Decline of the Chinese domestic price is starting to close the Arbitrage gap with the imported coal.

• Both Indo and Aus coal are losing competitiveness – export growth from the #1 and #2 exporter in the world will slow.

• Price differentials driving the trade flows

• Colombia and Russia competitive on the European market while USA and S. Africa are quickly losing market share

• The trend is expected to continue well into 2015 with Russia gaining further market share

13

Share of unprofitable export capacity

Long-term supply drivers (Global)

• Significant amount of mining output (20-25% of total) already unprofitable

• The process of Idling and/or permanently closing capacity is very likely to continue at these levels

• Mining capacity utilization is already declining – sure sign of capacity closures

0%

13.7%

25.4%

49.2%

76.1%

98.2%

3.3%

1.2%

Unprofitable export capacity

Thermal coal mining capacity utilization

Production vs. Average cost of production (current year)

450.1 mln t

333.9 mln t $54.75

$71.21

$50

$55

$60

$65

$70

$75

300

320

340

360

380

400

420

440

460

PACIFIC ATLANTIC

Average production price ($/t, rhs) Production capacity (mln t)

$30

$40

$50

$60

$70

$80

$90

$100

$110

$120

$130

$140

$150

Jan12 May12 Sep12 Jan13 May13 Sep13 Jan14 May14

FOB NWC

FOB RB

FOB RUS

FOB COL

50%

55%

60%

65%

70%

75%

80%

85%

90%

95%

100%

Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 May-14 Jul-14

TOTAL ATL TOTAL PAC

14

Major exporters (Mln t/quarter)

Exports growth rate

• Indonesian exports likely to stabilize around 108 mln/quarter

• Same for Australia @ 50mln/quarter

• Russia the only major growth region

Long-term supply conditions

• Export YoY growth rate diagram confirms these findings

• Russia the highest growth region for exports

0

20

40

60

80

100

120

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2F

Q3F

Q4F

Q1F

Q2F

Q3F

Q4F

2011 2012 2013 2014 F 2015 F

Indonesia Australia Russia

Colombia South Africa US

-40%

-20%

0%

20%

40%

60%

80%

100%

Q1 Q2 F Q3 F Q4 F Q1 F Q2 F Q3 F Q4 F

2014 F 2015 F

US South Africa Colombia Russia Australia Indonesia

15

Major importers

Imports growth rate

• China to continue with similar import rates for another year or so

• India the only other major destination

Long-term demand conditions

• China and India to dominate the import market in 2014-2015

-

10.0

20.0

30.0

40.0

50.0

60.0

70.0

80.0

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2F

Q3F

Q4F

Q1F

Q2F

Q3F

Q4F

2011 2012 2013 2014 F 2015 F

China Japan South Korea IndiaTaiwan Germany UK

-40%

-30%

-20%

-10%

0%

10%

20%

30%

Q1 Q2 F Q3 F Q4 F Q1 F Q2 F Q3 F Q4 F

2014 F 2015 F

UK Taiwan Japan China South Korea India Germany

Strictly private and confidential

Disclaimer This presentation has been prepared by Marex Spectron for information purposes only. Marex Spectron does not give any representation or warranty, whether express or implied, as to the accuracy, completeness, currency or fitness for any purpose or use of any information in this presentation. Information in this presentation should not be considered as advice, or as a recommendation or solicitation to purchase or otherwise deal in securities, investments or any other products. It has been prepared for institutional clients is not directed at retail customers and does not take into account particular investment objectives, risk appetites, financial situations or needs. Recipients of the presentation should make their own trading or investment decisions based upon their own financial objectives and financial resources. This presentation may contain forward looking statements including statements regarding our intent, belief or current expectations with respect to Marex Spectron’s businesses and operations, market conditions, results of operation and financial condition, capital adequacy, specific provisions and risk management practices. Readers are cautioned not to place undue reliance on these forward looking statements which may be subject to change without notice. While reasonable care has been used in the preparation of forecast information, actual results may vary in a materially positive or negative manner. Forecasts and hypothetical examples are subject to uncertainty and contingencies outside Marex Spectron’s control. Past performance is not a reliable indication of future performance. The Marex Spectron® group of companies includes Marex Financial Limited, Marex USA Limited, Marex North America LLC, Marex Hong Kong Limited, Spectron Energy Services Limited, Marex Spectron Asia Pte Limited (individually and collectively “Marex Spectron”). This presentation was approved by Spectron Energy Services Limited (“SESL”). SESL is incorporated under the laws of England and Wales (company no. 03938219 and VAT registration no. GB 872 8106 13) and is regulated by the Financial Conduct Authority (registration no. 193027). SESL’s registered address is at 155 Bishopsgate, London, EC2M 3TQ.

FINANCIAL COAL DESK LONDON: +44 20 074 2087 Nick Lygoe, Co-Head of Financial Coal SINGAPORE: +65 64 130 055 Arne Petter Kolderup, Senior coal swaps broker USA: +1 212 584 3896 Ian Tapsall, Head of US Financial coal PHYSICAL COAL DESK LONDON: +44 20 7074 0889 James Ash, Physical coal broker SINGAPORE: +65 6413 0055 Samaan Rahman, Physical Coal Broker USA: +1 646 312 6473 James Bleuer, Physical coal broker FERROUS METALS DESK OSLO: +47 2389 4218 Kristian Thunes, Head of Ferrous metals SINGAPORE: +65 6413 0060 Benjamin Beng, Iron Ore broker COMMODITIES RESEARCH DESK LONDON: +44 2076 5563 57 Georgi S. Slavov, Head of Basic Resources Research Group SINGAPORE: +65 6413 0045 Erlend Engelstad, Senior Research Analyst