With commodities markets currently experiencing extreme price swings, commodities traders face difficult challenges, both in ensuring that their contracts remain profitable and because of the increased risk that their counterparties will be unable or unwilling. to fulfill their contractual obligations.
What is happening?
Global energy markets have been in the news recently due to high prices, particularly due to the current gas crisis in Europe. Other commodity markets are also volatile. Copper prices topped US $ 10,000 per tonne during LME week, and prices for agricultural commodities such as coffee and wheat have also risen sharply this year, while prices for iron ore and palladium have fallen. .
Given the uneven nature of the post-pandemic economic rebound, the impact of the energy transition, and lingering geopolitical tensions, it seems likely that commodity prices will continue to move in unpredictable and significant ways.
When there is a large price movement between the contract date and the delivery date, there is a risk that a commodity contract will become unprofitable for a trader or his counterparty. This can expose traders to financial risk to their own business, or the risk that their counterparty will default, either because the contract has become commercially unattractive or because of insolvency. In the LNG market, for example, cargoes have seen their prices quadruple in recent months. Even the most resilient buyers will find it difficult to absorb this level of rise.
How can traders protect themselves?
In today’s extreme business environment, not all the usual “common sense” measures are capable of offering cast iron protection. Hedging against fluctuating prices is much more difficult in an unpredictable market. And while traders may choose to limit their exposure by increasing their activity in the spot market for new contracts, many are already stuck in existing longer-term contracts. We identify some of the steps available to traders below, noting limitations where applicable.
1. Credit checks
It is common for sophisticated commodities traders to perform credit checks and other due diligence on their counterparties, especially for longer term, higher value, or higher risk transactions. Such processes are even more important in today’s market environment, where circumstances can change rapidly and the creditworthiness of a previously reliable party may be suddenly or unexpectedly affected.
2. Credit insurance
For similar reasons, credit insurance may be a prudent option for higher value or higher risk transactions, even in the face of higher premiums.
3. Payment guarantees
Payment guarantees are simple in principle: if you are concerned about your buyer’s creditworthiness, you can require a third party to guarantee their payment obligations. However, this only offers effective protection if the guarantor (eg a parent company) is himself good for the money and therefore it is advisable to perform credit checks on both. It will also depend on the terms of the warranty, so careful drafting is essential. The best protection is offered by a demand guarantee (such as a stand-by letter of credit) which is a âprimaryâ obligation, enforceable independently of the sales contract. A standard guarantee is less effective because it is a “secondary” obligation, enforceable only if the beneficiary can demonstrate a breach of payment obligations under the sales contract – which can give rise to dispute, dispute and delay recovery
4. A âpre-mortemâ on the key clauses
A counterparty seeking to withdraw from a contract rendered unprofitable by market movement will likely turn to particular clauses to provide a loophole. These include in particular the right of termination, description and quality clauses giving rise to a right of refusal and force majeure clauses. For certain transactions, it will be advisable to carry out a “pre-mortem” on these clauses. This is undertaken before the start of the contract to identify what could happen to endanger it by a counterparty by relying on one or more of these clauses. It is then possible to anticipate to prevent or mitigate these risks and increase the chances of success of the contract.
5. ipso facto clauses
“Ipso facto” clauses are relatively common in commodity sales contracts and allow termination of a contract due to the insolvency of a party. However, the local laws of certain jurisdictions, including the United Kingdom, Australia, Singapore and the United States, will affect the enforceability of these clauses. Traders must therefore consider whether an ipso facto clause will give them the protection they expect in the event of the insolvency of the counterparty.
6. Stress test of your price revision clause
Standard price revision clauses may not be adequate to deal with current volatility. Taking corrective action could prevent exposure. We have advised a number of parties to existing long-term contracts seeking to renegotiate these clauses.
Taking early action can reduce the risk to a trader’s business. We actively advise our clients on these matters. If you have any questions regarding any of the above, please do not hesitate to contact the authors of this briefing note.