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.
Cancelled Contracts
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 be.
Market Discipline
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.
Current Thinking
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?
