Four Supply Agreement Considerations

In exchange for the volume guarantee a supply agreement provides, sellers forgo the opportunity to take advantage of any price spikes on the volume they agree to provide to buyers. In return, they receive steady income for a portion of their supply. Buyers, meanwhile, form a hedge against all material going to spot market and benefit from the security of having a portion of their supply delivered to the facility.

Neither the buyer nor seller can know what future price will be. Price is a reflection of supply and demand, both of which fluctuate from period to period. Supply may be constricted when a forest “grows through” an age class gap or when weather temporarily disrupts harvests. Demand may decrease when a facility is shuttered or increase when a new competitor enters the market.

In order to protect themselves from the price risk inherent in wood markets, those entering into supply agreements should consider the following four attributes of credible supply agreement indexes.

Index Geography

When structuring a supply agreement, 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.  For instance, in its own procurement zone, Facility A consumes 20 percent of the pine pulpwood. Higher consumption rates have a tendency to drive the index price higher. As a result, the geography for the purpose of the index should expand the procurement zone until Facility A represents just 10-12 percent of the market.

Market Structure

A number of forest products come out of any one harvest and, as a result, buyers must clarify the percent of each product they require for their manufacturing process. The use of 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.

Cash Flows

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.

Additionally, significant increases (and decreases) in diesel impact both harvest and freight costs, which in turn affect the cash flows of both the buyer and the seller. There are two ways to address periods of rapid or prolonged increases and decreases.

The first is to place a clause in the index where each party decides what an overactive or underactive price period looks like. If 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.

Credit Worthiness

Different buyers have different strengths. Some can offer longer terms, while others 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. In these cases, price premiums can be used to reward consistency, and ultimately keep, credit-worthy buyers and sellers.

Of course, these are just the basics when it comes to supply agreements. In addition to these four areas, 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.

Perhaps the most important consideration is to develop a robust and consistent index that is constructed by a neutral third party. Only those without a vested interest in the outcome of a supply agreement can structure an unbiased index.

Comments

daniel fitzgerald

02-06-2014

Is there operations in or close to So Cal? Looking to purchase bulk absorbent material below .20 cents lb delivered FOB San Diego for our new universal spill mat-

Thank you

Daniel