Price risk is inherent in wood markets. Supply agreements spread that risk. In exchange for the volume guarantee a supply agreement provides, sellers maintain a steady income for a portion of their supply but forgo taking advantage of potential price spikes on the volume they agree to provide. Buyers receive a hedge against all material going to the spot market and the security of having a portion of their supply delivered to their facility.
Properly structured wood supply agreements protect buyers and sellers from the unknowns associated with future prices. Credible indexes typically account for the following four attributes:
A number of forest products come out of any one harvest, requiring buyers clarify the percent of each product they require for their manufacturing process. An index that assumes a percent mix that is out of line with what a facility actually uses can over- or under-inflate price, depending on the scenario. Insight into the nuances of wood basins and what alternative markets are available to suppliers is also paramount.
The index should look at market prices within a geographic area where the buyer represents no more than 10-12 percent of the market demand as higher consumption rates have a tendency to drive the index price higher. If Facility A consumes 20 percent of the pine pulpwood in its procurement zone, the index should expand the procurement zone geography until Facility A represents just 10-12 percent of the market.
Buyers and sellers must come to an agreement on whether they will use market price at the end of a period or going into a period. There is no right or wrong answer, but having an answer helps dealers, who are essentially small businesses, manage their cash flows. Buyers and seller should also decide how to address significant increases (and decreases) in diesel that impact harvest and freight costs.
To address periods of rapid or prolonged increases and decreases, buyers and sellers can define an overactive or underactive price period by placing such a clause in the index. When the conditions of this clause are met, both parties know it is time to renegotiate. An alternate solution is simply to construct an index with a 90-day rolling average.
Some buyers can offer longer terms, while other buyers can buy more on a tons per year basis. Likewise, some suppliers may be able to consistently deliver quantities that no one else in the market can. Price premiums can be used to reward consistency, and ultimately keep, these credit-worthy buyers and sellers.
In addition to these four basics, buyers should consider defining the minimum quality of materials they will accept to meet plant specifications. Both parties will also need to agree on terms that will allow them to break the agreement and with what notice. Giving the proper attention to these caveats will help ensure supply agreements are structured to spread price risk equally among both parties.