Volatility in Commodities Pricing & Supply – 3 key risk areas of a trading contract

 

The commodities market has seen unprecedented market volatility in recent times as supply chain disruptions caused by Covid, the Ukraine crisis and changing geo-political circumstances have led to significant price swings across various groups of commodities. The energy crisis has affected the LNG, coal and oil markets while the agri-sector was squeezed by disruptions in the Black Sea with some nations placing export restrictions on their agri products. At the same time, China’s rebound continues to affect the metals market. The price volatility has meant that trading contracts are continuously being tested by external events and internal attempts to renegotiate price or jettison contracts for more profitable ones with minimum exposure. We look at 3 key risk areas of a trading contract that should be carefully examined in a volatile market.

Termination

Volatility may mean that a contract cannot be performed at the previously agreed price or timeframe. A change in pricing or supply chain issues however is not a reason to renege on performance of a contract and failure to perform certain obligations may trigger rights of termination. It is important to note that not every breach of the contract will entitle a party to terminate it. Broadly speaking, termination is only possible if a term breached is so important that any breach of it allows for termination (such terms are called “conditions”); or where the breach of a term that is not a condition is so serious that it deprives the innocent party of substantially the whole benefit that it was intended to get from the contract. In a trading contract, various milestones might trigger termination rights including the failure to open a letter of credit or to load goods by the agreed time. In addition, under English and Singapore law, matters relating to the quality, fitness for purpose and description of the goods are implied at law as conditions.

It is clear that non-performance of conditions at the time of performance can lead to termination. But what happens if a party wishes to terminate ahead of time for performance or has declared its inability to perform ahead of time because the contract is unprofitable? Should an innocent party have to wait till the contracted time for performance when its counterpart has expressed an intention not to perform? In such cases, the concept of anticipatory breach under common law provides a sword to cut the contract off. It requires a clear, unequivocal expression by words or conduct (in light of all the circumstances and history of the commercial relationship) that leads a reasonable person to conclude that the party does not intend to fulfil its contractual obligations. Thus, where a seller charterer was unable to secure a buyer for the cargo and could not confirm to the vessel owners if it would load the cargo and perform the charterparty when the vessel arrived at the loading port, the charterer was found to be in anticipatory repudiatory breach of the charterparty.

It is important to note that a breach (whether actual or anticipatory) does not automatically terminate a contract. It must be “accepted” for the contract to be terminated with a clear unequivocal communication that the contract is being treated as at an end. This is particularly critical when the repudiation relates to pricing because until the breach is accepted, the contract is still alive and a change in market pricing might result in a reversal of a previously unwilling party which suddenly finds the market has swung in its favour. There are three further important points which should be considered when exercising the right to terminate:

  • It is important to be on sure footing that the breach in question entitles a party to terminate, because an unjustified attempt to terminate can itself amount to repudiation (which would allow the counterparty instead to lawfully terminate the contract and claim losses).
  • Care should be used with the language used in any renegotiations of the contract so as to not commit an anticipatory breach of the contract. Over-enthusiastic attempts to express economic hardship when attempting to renegotiate better terms, might inadvertently put a party into a repudiatory breach.
  • Exercising the right to terminate pursuant to a contractual right may eliminate the possibility terminating for a repudiatory breach at common law if the contractual consequences of termination are inconsistent with those available at common law. The interplay should be carefully considered in each case.

Force majeure

Supply disruptions often produce a knee jerk response of force majeure (“FM”). The Ukraine conflict, export bans of palm oil and coal in Indonesia, closures at Chinese ports, and Russian related sanctions were associated with a loose invocation of FM. FM is a creature only of contract and the extent to which it can be invoked depends on the precise clause in question. Key areas to analyse in a force majeure is the trigger event identified in the contract, the causative link between the non-performance and the alleged FM event and the obligation to mitigate the position caused by the FM event. The most common problem with FM declarations is taking a “one size fits all” approach across the entire supply chain – this exposes a fallacy in the back to back world of trading contracts because what is FM in one contract might not be a valid FM down the chain. In a chain of contracts, the buyer closest to the producer is likely to contract for origin specific commodities. So for example, if a mine shuts down because of a flood or there is a national ban on export, this is likely to affect the immediate buyer of Chilean LME grade copper cathodes and may constitute an FM event depending on the language of the clause. However, the same event may not necessarily constitute a FM event if subsequent parties in the chain contracted for non-country specific LME grade copper cathodes in their contracts. It will not generally be sufficient justification for a seller to refuse performance on the basis of its supplier’s FM and the seller would be compelled to secure alternate supplies of LME cathodes. The ability to transpose an FM event gets more difficult when one looks at the multitude of contracts of international trade, for example, an FM by a miner is unlikely to be relevant to the shipowner from whom a buyer has chartered a vessel to take delivery from the seller – a trading contract FM does not neatly translate onto a charterparty.   

Often, attempts to declare FM are aimed at avoiding economic hardships when prices spike. When the Ukrainian crisis started, oil traders started self-sanctioning from Russian origin crude which meant non-Russian crude prices skyrocketed. A more expensive contract does not generally excuse performance and in any case, when analyzed properly, one could discern that it was not sanctions that caused the alleged inability to perform but the higher costs of sourcing crude. The causative link for FM cannot therefore be made out.

Exception clauses

Price spikes may also incentivize sellers to abandon committed contracts in favour of more profitable contracts with other buyers. Such speculative behaviour might be encouraged by the presence of clauses seeking to limit or exclude liability (collectively called “exception clauses”). LNG contracts which traditionally contain such exception clauses provided a recent example but price spikes meant a jettisoned contract with a 10% liability would be dwarfed by the potential profits in the tens of millions. There is continuing debate whether an exception clause can be deployed for such fundamental or deliberate breaches of contract, which would otherwise negate the contract to effectively an option to perform (or not, at a fee). Once again there is no one size fits all approach, although the prevailing guidance turns on factors such as:  

  • The purpose of the contract and circumstances in which it was made are important to the interpretation of exception clauses;
  • Clear words must be used for excluding or limiting liability under the contract; and any ambiguity must be resolved against the party relying on exclusion / limitation; and
  • Exception clauses are to be limited to the particular circumstances that parties had in mind when they entered into contract.

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