Resources Contracts: Mining for Profits After Force MajeurePublished: March 29, 2011 in Knowledge@Australian School of Business
Queensland's recent floods were so disruptive that major coal producers – Xstrata, BHP Billiton, Anglo American, Macarthur Coal, Rio Tinto and Peabody Energy Australia – declared force majeure, a legal let-out clause that allows them to break or suspend customer sales contracts without penalty. Extreme weather had a major impact on supplies as Australia is the world's top exporter of coking coal, used in steelmaking, and the second-largest of thermal coal, used to fire power stations. About 85% of the state's coalmines shut down and more were affected when Cyclone Yasi swept through Queensland in the first days of February.
While the resources industry was left reeling, market leaders including BHP Billiton, Macarthur and Wesfarmers Resources, are quietly securing the best possible deals in the future by changing the way force majeure contracts are struck, with key obligations in contracts being completely redefined.
Central to the rewrite is a push by BHP Billiton to shift coking coal contracts that are currently negotiated on a quarterly basis to a monthly arrangement. But steelmakers are opposing their efforts. Due to strong demand for coking coal after the floods severely reduced supplies, mining heavyweights have decided they are being disadvantaged by current force majeure contracts and want to cancel delivery rather than "carry it over" at the old price.
According to Glyn Lawcock, a resources analyst at financial services firm UBS, when coking coal prices were set yearly or quarterly, force majeure meant a lot more tonnes of coal were carried over to a later period. "It was an issue for miners. They left dollars on the table by delivering tonnes at the old price rather than selling into the spot market for a lot more money," he says.
In a note to clients, Merrill Lynch resource analyst Peter O'Connor reports that Marius Kloppers, BHP Billiton's chief executive, is rethinking force majeure contract provisions as new sale agreements are negotiated. "BHP wants to ensure that people don't understate sales impact in the first quarter of 2011 as sales run well below production while stock positions are rebuilt throughout the inventory chain," O'Connor notes. Producers want the option to terminate rather than suspend contracts as has customarily been the case, O'Connor claims. "At present, BHP is looking to cancel at least 50% of supply it was contracted to deliver. Macarthur and Wesfarmers are cancelling up to 75% and 100% respectively," he says. "Eventually though, it is expected that all sales could be cancelled under new force majeure contracts."
Pricing Ups and Downs
Until the 2008 floods, force majeure was not in focus as there was no massive "carry over" after devastating storms or floods. Markets were not contentious, prices were relatively stable and there were no major price fluctuations. But in 2008, business changed for miners and their customers. Floods in Queensland, combined with the boom in emerging markets, sent coal prices soaring. The floods were used as an excuse by miners to cancel delivery and profit from a higher spot price. This led to disputes with energy-hungry steel mills, clearly unhappy at having their access to coking coal denied. The mills could often identify what should have been their assignment of coal sitting at a port due for export to another customer.
Subsequently, the global financial crisis hit and the tables were turned dramatically. Customers reneged on their contracts when demand fell and production slowed. Commodity contracts came under extreme pressure. Global heavyweights, such as BHP – due to financial strength and global reach – could hold mills to account, but smaller resources groups suffered.
Now, with commodity prices skyrocketing, the miners are back on a strong footing. Extreme weather continues to cause widespread disruption to the industry and is also affecting the international commodities market. For example, some South African mining firms exploited the early warnings of the Queensland floods and built up stockpiles, reduced fixed price contracts and took advantage of a rising spot price.
According to Robert Milbourne, a mining and resources partner with global law firm Norton Rose, the cost of such devastating weather events and the ever-growing loss of infrastructure should push global miners to better assess the threats from floods, cyclones and storms, and rethink how these catastrophes will affect their operations and customers worldwide.
"Three years ago there was a sudden tripling of commodities prices. This same dynamic has reoccurred with the most recent Queensland floods resulting in a near doubling of coking coal prices. Now with mine assets and export commodities worth more than ever, even short delays to production and export can have dramatic financial impact. The cost of major infrastructure projects has increased considerably and consequently there are higher values across the supply chain. Hence the risks are now greater."
Extreme weather events are certainly not new, but their effect on resources businesses may be more severe now than in the past, Milbourne believes. Mining businesses must now focus on the consequences of non-delivery due to weather."It has to be taken more seriously by companies and end-users alike," he says.
Suspenders or Terminators?
Force majeure is a term used to describe something that is beyond the expectation of each party. It's not a uniform concept and there is no definition that applies to all contracts. It's rare to see identical force majeure clauses, Milbourne points out. In Milbourne's view, force majeure has for too long been relegated to the back section of contracts and not considered a key commercial consideration.
"Variations between contracts can have important consequences– for example, the distinction between a force majeure clause that results in the suspension rather than the termination of a contractual obligation," Milbourne says. "The two options can have very different financial results." Specifically, managers must consider whether delivery will be postponed or cancelled after a severe weather event. "Managers might look to sell stockpiles of product declared undeliverable into the spot market once operations start up again," Milbourne says. "With spot prices being so high for coal, selling into the spot market will have a huge impact on profitability and cash flow."
Notably, some companies appear not to have learned from the 2008 floods. Otherwise, Milbourne says, there would be a better general understanding of suspension versus termination following force majeure events. There would also be more insight into how coal producers with multiple contracts – who are affected by force majeure – choose who gets coal and who does not.
A total shutdown of a mine due to bad weather is rare. Often partial mining is possible or companies have stockpiles they can transport before a mine is flooded. Where a company has many contracts, Milbourne advises, it may still be able to deliver against some of them. But how that is decided can be difficult. There may be value in considering this allocation as a commercial matter. "Right now, there's little understanding of the consequences with multiple-sourced relationships," Milbourne says. "Perhaps buyers can get a better price deal with weaker force majeure terms, for example. Or perhaps delivery is key, so allocation is a priority and customers will pay more for that right." The law of allocation in the event of force majeure is evolving and there is little certainty or consistency internationally concerning the rights of the producer or off-taker in such circumstances.
Although some of the world's top miners have moved to improve the scope of force majeure contracts, most companies are lagging, in Milbourne's view. Commercial contracting needs to catch up with reality. The stability of the supply chain is in everyone's long-term interest. What's needed is a meeting of minds, Milbourne suggests. Increasing frequency of extreme weather may cause natural disasters to no longer be considered as extraordinary events that are beyond the reasonable expectation of either party. They may even be considered foreseeable. Certainly, some South African companies recently profited from the early flood warnings.
"We do anticipate earthquakes and floods so the question isn't whether these events are unforeseen. However, companies don't know exactly when they will occur, how devastating they will be and often are unable to predict their impact," says Leon Trakman, a law professor at the University of New South Wales, who agrees that force majeure clauses are often poorly drafted. This may be intentional – because companies don't know what the future will bring and want flexibility – or because contracts are drafted by managers in a vacuum, rather than by more senior people who negotiate the multi-million dollar contracts, Trakman says, noting that many contracts are "boiler plated" and feature repetition of previous clauses. But they serve the purpose of supplanting the legal process. "The law has a much narrower view of excuses for non-performance and courts will not provide relief if someone wants to walk away, unless it sees that the contract permits it," he says.
"The problem is that everyone wants it both ways. Companies want to be able to continue with a contract if they can, but walk away in extreme cases. Who knows in advance what the extreme case will be, and who decides? So companies sometimes draft flexible and ambiguous clauses deliberately – because they anticipate the need for a possible escape valve or because they want to deliver on the contract – whichever is the better of two evils. They want a quick contractual solution, rather than a legal battle."
Heading Off a Storm
As a rule, weather-related information is not considered in allocating risks associated with contract performance, investment or off-take agreements. With flooding in Queensland in 2008 and 2011, steel mills might suggest that these events are predictable and, therefore,try to remove them as an excuse for not delivering. "If we say weather events are foreseeable then they need to be more expressly dealt with in the force majeure negotiations as a fundamental commercial term," Milbourne argues.
Some fund managers and financial analysts find the lack of transparency around contracts dissatisfying. "If major commodities suppliers and steel mills are secretive and fuzzy about their supply chain stability and how that is negotiated into contracts, it adds to uncertainty," one fund manager says."When publicly listed companies achieve much of their revenue from the sale of a limited number of commodities those contracts are very material and not disclosing terms is a real issue. Shareholders are being mislead."
Lawcock also identifies grey areas. "Force majeure is a problem because we don't know what tonnes are going out at what price," he says. "If companies are cancelling contracts now more than they used to, then what typifies force majeure becomes a stumbling block – although it is perhaps less relevant with a move to monthly contracts."However, prices could still spike in one month and supplying customers at the old rate could hurt miners' profitability. Not all commodity contracts will move to monthly. "Investors need to know contracts will be honored," says Lawcock. "There are two things analysts worry about – companies getting paid and having more rigour around force majeure. If you lose production, you can't magically produce tonnes for the next quarter."
Australia has become a riskier place to do business because of a string of big natural disasters over the past few years. Companies need to adjust their strategies accordingly as investors start to evaluate weather management as a significant factor when considering investment in resource companies or associated infrastructure projects. Mineral resource exports are expected to reach A$186 billion for the 2010/11 financial year, rising by 16% to A$215 billion for 2011/12 as strong demand from China and India extends Australia's commodities boom. More records will continue to be broken in the minerals and energy sector, according to the Australian Bureau of Agricultural and Resource Economics and Sciences, the government commodities forecaster, suggesting the contracts that include force majeure will be dominated by the mining industry.