01 Jun The Cost of Metal + Long-Term Agreements
Long-term agreements (LTA) reduce risk for both the manufacturer and buyer. That risk ranges from inventory supply to overall costs. One of the many factors that go into determining the language of bearing contracts is metal exchange rates.
Generally included in the LTA is a clause for a variation in raw material costs. For example, when the cost of raw materials changes by plus/minus five to seven for a sustained period of time, the manufacturer or buyer can renegotiate price. Bearing manufacturers are especially sensitive to the cost of steel as it has a significant impact on bearing production.
In the past, the LME or London Metal Exchange was used as the threshold for price fluctuation. As more metal is being consumed in China for production, the shift toward the Shanghai Metal Exchange (SHME) is becoming more common. The question is why?
In order to understand the price of metal, it is important to understand how pricing is determined.
Determining the Cost of Metal
Metal is considered a commodity and its price is controlled by supply and demand – both current and future supply and demand is factored into pricing. Sometimes speculation also plays a role in price setting.
Metal Commodity Exchanges
The leading commodity exchanges are:
- London Mercantile Exchange (LME) – A major exchange that offers exposure to futures and options of a wide variety of base metals and other commodity products, the LME began in 1877.
- New York Mercantile Exchange (NYME) – Based in New York, this exchange has two divisions – the NYME and the Commodity Exchange (COMEX).
- Shanghai Metal Exchange (SHME) – Established in 1992, SHME is a non-profit and self-regulating corporation for trading non-ferrous metals. It is the largest non-ferrous metals futures exchange in China and the third largest exchange of its kind in the world.
- Shanghai Futures Exchange (SHFE) – Shanghai Futures Exchange was formed in 1999 by bringing together the Shanghai Metal Exchange, Shanghai Foodstuffs Commodity Exchange and the Shanghai Commodity Exchange.
China is the epicenter of manufacturing and production for a range of products. As global demand grows, so too does the need for raw materials. This can be seen in a recent quote from Reuters:
China accounts for just under half of global copper demand, which is estimated at around 23 million tonnes this year. (Reuters, March 14, 2017)
In 2015 the SHME added six additional industrial metals to the trading exchange to equal the number of metals on the LME. And, according to the Financial Times, daily liquidly on the SHFE is now surpassing the LME and Comex combined. It is also seeing some of the highest trading volumes in copper and zinc.
And, according to a December 2015 article on MetalBulletin.com, there is tighter correlation between the two markets that ever before.
SHFE close and London Metal Exchange open prices were more tightly correlated in the period January 2014 to the present than they were in the three years to December 2013, the Citi analysts found. “As such, we can deduce SHFE prices offer a good model or leading indicator to LME open prices,” they said. The analysts also considered the R2 (covariance squared) correlation, where a number closer to one indicates tighter correlation. In copper, this increased from 0.5 in the first period to 0.6 in the later period, while zinc increased from 0.4 to 0.49.
-MetalBulletin.com, December 2015 (SHFE driving global price discovery as LME volumes slide – Citi)
Many traders believe that SHFE has taken its place alongside the NYME Comex and LME as a key price indicator for global metal trading. And, because of its location in Shanghai, it allows traders 24-hour access to future contracts due to the time gap between the LME and NYME.
Exchange Selection for LTAs
Since both the customer and manufacturer want to use a public price as a reference point, it is important to select an exchange to cite in the agreement. A few factors to consider:
- Where is the product being produced?
- Where are the raw materials being sourced?
If a product is being manufactured in China, with raw materials coming from China, it makes sense to use the Shanghai Metals Exchange. The production workflow should determine the exchange, not an arbitrary preference.
Can’t Agree on an Exchange
In some cases under a LTA, a manufacturer will share its raw material invoices. Invoices can be shared on a monthly basis so that cost adjustments can be made on the 5 to 7 percent differential per actual costs.
However an LTA is configured, it needs to include a reference to a third-party source for raw materials in order for price variations to be fairly distributed among both parties.