Offtake agreements are important for many companies but are particularly crucial for those focused on critical and industrial resources such as crude oil, natural gas, metals, palm produce, limestone, lead etc. However, the development of the mining facilities of these resources is capital intensive. Many of these metals are not sold on the open market, and that makes it harder for producers to offload them. These realities necessitate securing an offtake agreement before commencing resource production.
What Is an Offtake Agreement?
· According to Investopedia, an offtake agreement is an arrangement between a producer and a buyer to purchase or sell portions of the producer’s upcoming goods. It is normally negotiated prior to the construction of a resource mining and/or production facility to secure a market for its future output.
· Offtake agreements are frequently used in natural resource development, where the capital costs to extract resources are significant and the company wants a guarantee some of its product will be sold.
· Having an offtake agreement tends to make it easier for producers to secure the necessary financing to move forward with mine/asset development and construction. Lenders and investors are more likely to have confidence in a project if they know that companies are already lining up to buy the tonnes of whatever resource it will produce in advance.
· This serves an important role for the producer. If lenders can see the company has clients and customers lined up before production begins, they are more likely to approve the extension of a loan or credit. So, offtake agreements make it easier to obtain financing to construct a facility.
· These agreements are legally binding contracts related to transactions between buyers and sellers. Their provisions usually specify the purchase price for the goods and their delivery date, even though the agreements are reached before any goods are produced and any ground is broken on a facility. However, companies can usually back out of an offtake agreement through negotiations with the other party and with the payment of a fee.
· Because the agreement is negotiated far in advance, often before construction of the manufacturing facility and actual production has begun, buyers lock in a price and guarantee the supply of a product to protect against future economic and market uncertainties.
Benefits of Offtake Agreements
i. In addition to providing a guaranteed market and source of revenue for its product, an offtake agreement allows the producer/seller to guarantee a minimum level of profit for its investment. Since offtake agreements often help secure funds for the creation or expansion of a facility, the seller can negotiate a price that secures a minimum level of return on the associated goods, and so lowering the risk associated with the investment.
ii. Offtake agreements may provide a benefit to buyers as well, functioning as a way to secure goods at a particular price. That means prices are fixed for the buyer before the manufacture of them begins. Doing this may act as a hedge against future price changes, especially if a product becomes popular or a resource becomes scarce, causing demand to outweigh supply.
iii. It also provides a guarantee that the requested assets will be delivered: fulfilment of the order is considered the seller’s obligation under the terms of the offtake agreement.
iv. Offtake agreements also include default clauses that outline the recourse—including penalties—either party has in case there is a violation of one or multiple clauses.
An Example in Agriculture
To illustrate how these agreements can play out in a business situation, here’s a simple breakdown of how offtake agreements work:
· Let’s say a company has been working on a new hybrid of soya bean but is looking for financing to develop this new project before it is actually produced.
· In order to ensure financing, the company signs an offtake agreement with a soya bean trader/institution that is interested in selling the soya beans once they are produced. Under the terms and conditions of this contract, the soya trader agrees to buy all the future production of soya beans that the company intends to produce during the next year.
· The soya bean producer can assure investors and lenders that there is a market for its product before it begins production. It can also be confident that it has ensured a minimum return on its goods.
· The soya trader can continue functioning as normal because it knows that it has secured supply of soya beans for a particular price and for delivery at a particular date.
This same principle is applied across agriculture, oil & gas, manufacturing and several other sectors globally. Regulators of these industries typically do not approve licenses for resource extraction and mining without a signed offtake agreement in place.
Offtake Agreement Risks
While offtake agreements have many benefits for both producers and buyers, it’s important to note that there are risks associated with them as well.
It’s possible for both parties to back out of an offtake agreement, though doing so requires negotiations and often the payment of a fee. Companies also face the risk of not having their offtake agreements renewed once they are in production — and they usually must make sure that their product continues to meet the buyer’s standards.
Offtake agreements can also be complicated and can take a long time to set up. For mining companies that want to move forward with the development of their projects quickly, spending that time can be a hindrance. These companies may choose to progress on their own.
Special Considerations for Offtake Agreements
Force Majeure
Most offtake agreements include force majeure clauses. These clauses allow the buyer or seller to cancel the contract if certain events occur deemed outside the control of either party and if one puts unnecessary hardship on the other. Force majeure clauses often provide protection against the negative impact of certain acts of nature such as flooding or wildfires.
Producer Price Index (PPI)
The producer price index (PPI) is a family of indexes that gauges the average fluctuation in selling prices received by domestic producers over time.
Repurchase Agreement (Repo)
A repurchase agreement is a form of short-term borrowing for dealers in government securities.
Red Clause Letter of Credit
A red clause letter of credit is a specialized financing method in which a buyer extends an unsecured loan to a seller.
Countertrade
Countertrade is a reciprocal form of international trade in which goods or services are exchanged for other goods or services rather than for hard currency. This type of international trade is more common in lesser-developed countries with limited foreign exchange or credit facilities.
Sources: Investopedia, Investing News, Emeka Iheme
