When is a contract not a contract? Most of us – particularly
those from an LME background – assume that once a deal is agreed, then it will
proceed smoothly through the physical exchange of goods and payment. That’s
what convention tells us should happen, that’s what the law broadly expects to
be the case. But it isn’t always so straightforward.
Sharing Price Risk
Take the stainless steel industry. Some of the alloying
elements (nickel, cobalt, moly, for example) are relatively of very high value,
compared with the basic bulk metallic inputs. They also have periods of extreme
volatility. Those two factors combined create an environment where fair pricing
is difficult. The producer has to buy his alloying elements, particularly
nickel, on an LME-based formula of some sort, but his customer, for argument’s
sake let’s say a service centre, wants to buy on fixed price. That leaves the
producer exposed to fluctuating nickel prices and to avoid the problem the
chosen method has been to apply a nickel surcharge to the stainless sale, which
is derived by averaging LME nickel prices over a period to avoid the risk of
spikes. It’s not perfect, but it’s been tried and tested over a long time and
provides at least a form of equity in sharing the nickel price risk.
However, if the nickel price drops sharply between order and
delivery there is the risk that the historically-based surcharge will be
substantially higher than the actual LME nickel price at the time of delivery;
or, in the opposite scenario, the surcharge will be lower than the LME nickel
price. Given the volatility of nickel, both occur fairly frequently, so really
one would conclude that over a period they would broadly cancel each other out,
and the trade could function successfully on that basis. Sadly, though, that’s
not the case. Given the opening premise that a contract is a contract, it’s
disturbing how frequently material is simply cancelled by customers when the
nickel price drops. While I can understand the frustration of paying over
current market price, nevertheless reneging on contracts is hardly the
solution. Stainless producers traditionally have been surprisingly
accommodating of this; as far as I am aware, there is not a bulging file of LME
arbitrations or civil lawsuits around the subject. But honestly, there should
While we all know that ‘the customer is always right’, I
find it difficult to stretch that concept to take in the use of a purchase
contract as a kind of proxy for a nickel option trade. There are plenty of risk
management tools and plenty of experts (me included) always willing to help
buyers and sellers make use of them to mitigate their exposures. Producers have
been lenient in tolerating the disruptions caused to their order books by
semi-committed buyers; for their own sakes, they should be a little harsher and
take some of the contracts to arbitration. That would probably help the
discipline of the market.
Long-term Frame Contracts
Here’s another one, from the opposite end of the contract
size spectrum. To help ensure continuity in their operations, mining companies
and smelters like to conclude long-term frame contracts for the supply of
concentrate from mine to smelter. These contracts are often of very long
duration, maybe up to ten years, obviously therefore creating a fair degree of
price risk. The mitigation of that is by setting the base price against a
(hedgeable) LME formula, and leaving the flexible part of the price – the TC/RC
– to be agreed on an annual basis throughout the life of the contract, thus
theoretically keeping the price close to the reality of the market at the time.
That typical structure has, to the best of my knowledge, been the basis of
long-term copper concentrate frame contracts for many years.
Failure to Agree
Now, the problem will occur when the two parties are unable
to agree the TC/RC for a year. Conventionally, if they have failed to agree,
the contract has taken a holiday, and resumed in subsequent years. Clearly,
since the market in TC/RCs is mature and accessible, this is a situation which
is relatively rare, but not unknown.
However, what I see coming out of the courts at the moment
suggests a little more care may be needed. The courts currently appear to be
saying that if agreement is not reached, then one or other party may take the
contract to a court or an arbitration tribunal and request that forum to
adjudicate the level of discount/premium. In other words, if you really want
the agreement to agree to allow for the possibility of non-agreement, then you
need positively to include reference to a benchmark level, or to the
possibility of the contract taking a holiday in the event of non-agreement.
Simple reliance on the fact that, certainly in English law, you cannot purely
agree to agree would no longer appear to be strong enough.
So, contracts as proxies for options; questions of contract
enforceability. More law in one, less in the other?