Question

Commodity pricing contracts are being used for managing risk in long term producer-processor contracting relationships. Analyze challenges of using long-term supply contracts. (10marks)

Answer 1

Commodity contracts has been used by both producers as well as buyer of commodity to hedge the pricing of the commodity but long-term supply contracts has its challenges. One of the major challenges lies with that the both parties should be in a position throughout the contract where it can meet the obligations of the contract. If any party is defaulting on its obligation, either the one who has to pay or the one who has to supply the commodity it can cause issue to the other party, so there is some counterparty risk. In the long-term supply contract, there might be some technological innovation which can significantly affect the pricing of the commodity but with the contract the buyer has to pay the agreed price. The long-term supply contract also raises the issue of being excessively dependent on one supplier for any commodity which can eventually increase his negotiation power. It can also lead to monopolistic behavior by the supplier. The long-term supply contract can also sometime create different issue from legal point of view if one party interprets the agreement in a different way than the other party.