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Long-term index-based contracts vs. Spot

market insights

August 26, 2019

The global market for ferroalloys and metals as raw materials for the iron & steel industry is well in excess of 150 Billion US$.

There are two main instruments for consumers to buy and for suppliers to sell ferroalloys and metals: long-term index-based contracts and spot. In most cases, companies apply a mix of these two instruments. This mix varies a lot from company to company and also over time.

Designing the “right” mix is one of the most strategic activities of purchasing and sales executives. One steel mill might buy 80% of raw materials under index-based contracts and only 20% in the spot market, while another may buy 100% in the spot market. So what are the advantages of the two instruments and how can one determine the optimal mix?

Benefits of index-based contracts

Definitely, index-linked contracts have advantages, below we list the most important ones:

  • Less work. Typically, index-linked contracts are annual contracts, valid for one year. Only one negotiation per year needs to take place and only one contract needs to be drafted and signed. This significantly reduces the workload. As one purchasing manager in a steel mill told Metalshub “We are a team of three, buying 25 products worth €400-500 million. Without index-linked contracts, it simply wouldn’t work.
  • Security of supply. With signed index-linked contracts from well-known counterparties, purchasing managers feel secure that they will receive the material. At the same time, sales managers feel secure that they will be able to sell the material. They have a contractual guarantee of the volume. However, there are limits to this security. Most index-linked contracts contain a force majeure clause. With this clause, the supplier can suspend shipments due to events out of his own control (strikes, accidents, natural disasters, etc.). Moreover, history has taught us that when the market goes into crisis mode, many buyers default on the volume agreed in annual contracts or open the contracts up for renegotiation.
  • Discounts on the index-price: From a buyer perspective, index-linked contracts can be very attractive because suppliers often offer discounts on the index-price. Sometimes the discounts can reach up to 30% of the index price. This appears to be attractive to purchasing manager because they can tell their boss “I’m always buying below the market price”. But is the index price really the market price?

Benefits of spot purchases

Having observed a trend over this decade that more and more volume has been bought through index-linked contracts, this trend recently seems to be reversing. A Head of Purchasing from a steel mill told us “I would like my purchasing managers to be more active in the spot market. Being in the market frequently helps to spot new developing trends earlier.” Here are some of the advantages of spot purchases:

  • Being “in” the market. Buying ferroalloys and metals regularly in the spot market, for instance, on a monthly basis, keeps the team informed about new trends in the market and provides unique market intelligence which is not available in the trade press.
  • Get the true market price. The methodology to establish index prices from price reporting agencies in most cases relies on personal interviews rather than “hard” trade data. Market participants who report trades to the price reporting agencies often have a trading interest and therefore an incentive to influence index prices. This can lead to inaccuracies. Moreover, changes in ferroalloy and metal prices are first observed in the spot market and are only reflected in index prices with a delay. In the spot market, the true market price is established. Index prices are “yesterday’s newspaper”.
  • Provide input to index prices. The index price can only reflect an accurate picture of supply and demand if there are enough transactions taking place in the spot market. So any buyer or seller who has a portion of his book based on index-linked contracts should have a keen interest to transact in the spot market to ensure that index prices reflect the fair market price.
  • Flexibility. Steel, ferroalloy and metal production volumes are volatile and cannot be perfectly forecasted. Unforeseen events such as an economic crisis or a furnace failure can happen. This leads to problems if the majority of the volume is bought or sold through index-linked contracts. It is possible to include volume options in index-linked contracts. However, these options have a value and a sophisticated sales organization will charge for the options. Buying a significant part of the volume in the spot market, gives buyers and sellers breathing space in case volumes don’t turn out as planned. Furthermore, for some products, there are substitute products available. For example, Chinese stainless steel mills can buy refined ferronickel, low-grade NPI, high-grade NPI or nickel metal to get the required nickel units for their production. Having a significant portion of the requirement left for the spot market, buyers can react to changing market situations and optimize the mix. Spot is ideal for the commercially agile!

What to consider to decide on the split between index-based contracts and spot purchases?

There are many factors to consider when determining the optimal mix between index-linked contracts and spot.

First of all, how liquid is the commodity. In general, the higher the liquidity of a product the more sense it makes to buy in the spot market. One sign of liquidity is that there are many buyers and sellers for a product in the market who actively participate in the price formation by providing bids and offers.

Secondly, the variability of your own operations. If your actual production, steel or metal, has historically had a high deviation from the planned production then this is an argument to transact a  larger portion of the volume in the spot market.

Thirdly, a strategic forecast of supply and demand over the coming 12 months can help to determine the optimal mix. In an oversupplied market, buyers will do better to buy a larger amount in the spot market. The reason is that weak fundamentals should drive prices down and spot prices lead index prices. For suppliers, of course, the opposite logic applies.

Finally, the available systems in your organization play a role. IT systems and tools can significantly reduce transaction costs which means that companies can afford to transact more frequently in the spot market. One such digital tool is Metalshub. It makes buying and selling in the spot market very simple and drives down transaction costs.

To conclude, our feeling is that too much volume is currently bought on index-linked contracts. Our prediction is that this will change going forward. Lower transaction costs through new IT systems and increasing unpredictability of production volumes will be key drivers for this development.

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