Summary

Over the past 12 months there has been a significant shift toward short term and market based pricing of export commodity sales contracts.  BHP Billiton expects this trend to continue in the medium to long term, with Marius Kloppers predicting that at least 60% of coking coal will be supplied under short term contracts or on a spot basis by the end of this year.

Over the past 12 months there has been a significant shift toward short term and market based pricing of export commodity sales contracts.  BHP Billiton expects this trend to continue in the medium to long term, with Marius Kloppers predicting that at least 60% of coking coal will be supplied under short term contracts or on a spot basis by the end of this year.

In addition, it has been reported that most of Rio Tinto’s iron ore sales contracts have been converted to short term pricing, with approximately 60% of iron ore sales based on a spot price index. BHP Billiton also moved as early as 2010 to three month contracts for coking coal for customers in Europe, China, India and Japan.

This change is not entirely unexpected. Many of Japan’s steel mills changed to quarterly pricing from yearly pricing in 2010, and whilst it hasn’t been confirmed, some of China’s steelmakers have reportedly signed contracts based on short term supply.

Short term pricing of commodities is likely to lead to greater fluctuations in commodity prices, indeed, we have already seen signs of this. This variance in commodity price is a significant change from the previous 5 or more years where commodity prices have (with few exceptions) steadily increased. Fluctuations in price together with the perceived uncertainty of short term contracts or market based pricing will in the near term affect some investment and the ability to obtain finance. While investors and financiers have previously had the comfort of steadily increasing commodity prices (and a very bullish view of future prices), they are now likely to take a conservative outlook.

A move to short term and market based pricing will mean significant changes to the terms and conditions of commodity sales contracts. Most mining companies will now need to adopt new forms of agreements. Those agreements could be set up on an umbrella basis – whereby at regular intervals parties agree tonnages (if any) and price and otherwise the terms and conditions are agreed. Alternatively, parties could enter into new agreements at the beginning of each period. The umbrella style agreement is a more efficient contractual mechanism as it requires less paperwork once the parties have agreed the tonnage to be supplied. There are however three areas of an umbrella agreement that parties often fall foul of. The first is that parties will need to be careful to ensure that their exchange of correspondence creates a binding order. Secondly, parties will also need to ensure that their exchange of correspondence does not unintentionally vary agreed terms. Further, for those parties adopting market indexes to set prices, it will be necessary to select an appropriate index and ensure that that index is accurately described in the agreement – for example, parties frequently reference an average price of an index when the index organisation does not publish an average price index.

Short term contracting will also have a significant impact on miners’ marketing teams. There will be a much greater need for travel, as marketing teams are more frequently negotiating price and tonnages. Alternatively miners will move parts of their marketing teams to central locations such as Singapore and Hong Kong.

Over time, we are likely to see additional impacts of short term commodity contracting. Miners will need to ensure that their port and rail contracts allow for spikes and troughs in production. This is a fundamental move away from the even shipping terms of most port and rail contracts in existence today. It will also require fundamental changes in the scheduling processes for rail and port. Like the current rail and port contracts, scheduling is premised on an even railings or shipping basis. With spikes and troughs in production there will also be more short term trading of port and rail capacity as parties try to minimise their take or pay obligations and obtain more capacity for short term production spikes. All of this means that there is both a need and an opportunity in the port and rail space for industry and government to reform the way in which port and rail capacity is contracted, scheduled and managed. Without this reform we will see continued inefficient use of port and rail capacity.

Ultimately, short term commodity contracting will benefit those miners who are able to share infrastructure (such as train loading) and flexibly turn up and down their production. This will promote innovating contracting (particularly with contract mining agreements). From a buyers point of view, short term contracting allows for a greater level of reactivity to certain events within the mining industry. Outside influences, such as natural disasters, can wreak havoc with contracts premised on long term delivery and minimum levels of supply. Shorter term contracting allows buyers to deal with these circumstances, without having recourse to possibly uncertain force majeure and delay clauses. 

In summary, short term contracting will have a significant impact on sales contracts, but also port and rail contracts, mining contracts and operations. Businesses which for some time have operated and set budgets with respect to steady, long term contracts will need to adapt to the changing face of commodity supply as prices become more variable. It is important to note however, that not all of that change is or will be negative. Greater flexibility can, if managed correctly, result in significant increases in revenues for firms that are able to adapt. There will however, be a need for some reform in the industry. In particular, the role of government and government owned corporations (particularly with port and rail) to ensure that the most effective regime is in place.