contracts and benchmarks

If the price on your purchasing (or supply) contract will be floating according to a formula that depends on a "benchmark", you should pay special attention to the following points:

1) There are liquid futures markets for several commodities. Benchmarks that are based on such markets are by definition "forward-looking." This is ideally what you want. At the beginning of each quarter, the price on your contract will be reset by factoring in price expectations for the next quarter.

Unfortunately, there is not a deep (i.e. hard-to-manipulate) futures market for every single commodity. For example, in the ferro-chrome business, the quarterly price that is collectively declared by major South African producers is often taken as the "forward-looking" indicator.

If your contract involves such a benchmark, then make sure that your counter party can not collude with the major producers who set the benchmark. It is not difficult to imagine cases where the major producers get side payments from your counter party for declaring a price that is favorable for him.

Often the physical markets have an air of competitiveness about them, but the reality can be quite different. So be inquisitive and gather some intelligence on your counter party's relationships.

Note that if the major suppliers have made a substantial switch to the spot markets, their price declarations will not have any binding effects even for their own future transactions. Especially in extremely volatile price environments, do not be surprised if nobody takes the "benchmark" seriously.

2) Sometimes (especially in very non-transparent markets) there may be no "forward-looking" benchmarks available. In that case you will have to rely on "backward-looking" indexes. The most frequently-used indexes are the ones published by leading commercial journals.

The intelligence that these indexes rely on is often quite shaky. Prices of past-transcations are pulled straight from the voluntary questionnaires that are sent to major commodity firms. These firms have all sorts of reasons to supply false data. (In fact, after tying the price formula on your purchasing contract to the journal's index, even you will be tempted to transmit false information by deflating the prices achieved on your recent spot deals.)

Indexes are open to manipulation even if the journal manages to collect data that is reliable on average. So make sure that your counter party does not have any "sweet" connections at the journal's headquarters. Note that these connections do not have to be at the top-level. Low-ranking officers are usually more open to cooperation. (These guys are easier to impress and manipulate. They are less experienced. They have less to lose. They also have more need for side payments and other "goodies".)

3) Of course, the silliest thing to do is to base your contract on a benchmark that is "technically" very easy to manipulate. Resetting the price on your annual contract according to the December 31st closing price of a derivatives market is not a good idea. Your counter party may step in just before the market closes, place a massive order and push the price towards the direction that is favorable for him. He may lose some money on the derivative transactions, but these losses will be easily offset by the annual gains he will be making on the physical contract that he signed with you.

4) If the contract stipulates delivery of a tonnage that is quite substantial in comparison with the size of the total market, then the contract will inevitably affect the benchmark it is based on. (Assume that the prices are temporarily down for some unclear reason. If this movement takes place in a fashion that affects the benchmark, then your contract will reinforce it and stretch its lifetime.) There is one simple way of preventing this endogenous interaction from happening: Do not disclose the price formula to the public.