A Force Majeure Clause is Quite Critical in Commodity Contracts

A force majeure clause is often added to a contract of commodities without careful consideration of its implications. An event must meet several conditions to be viewed officially as a force majeure. In the last few months, there have been several examples of force majure: ONGC Videsh (OVL), the overseas exploration arm of Oil and Natural Gas Corporation (ONGC), has invoked force majeure clause for its Libyan block (Cyrenaica offshore in the Mediterranean Sea) following a war-like situation in the African nation. In Japan, after the earthquake, several power companies and commodity suppliers have declared force majeure in order to postpone deliveries, orders and events. There is even talk that Japan may ask for exemption from the Kyoto Protocol in the wake of the disaster. 

The case of Japan reminds us that force majeure should cover multiple events as one event may lead to other relevant events including tsunami and nuclear leaks. It also indicates that force majeure clauses should be tightened to allow for exit, after a period of time. 

A force majeure (which means superior force in French) is defined as an event which is beyond ‘reasonable’ control. While force majeure clauses are drafted with varying degrees of sophistication in commodities contracts, the ability to enforce a ‘force majeure’ clause is determined by the precise drafting of the contract as several common themes run through a vast majority of clauses which are (1) force majeure event (2) causal connection (3) contribution to force majeure event and (4) Notice. 

The event and the causal connection must be outside the control of the parties and should typically be seen as ‘unforeseeable’ and ‘impossible’. A force majeure clause is critical in any commodity contract. It is viewed as fair because it is not only an “act of God” but one in which the parties would not have contemplated (e.g. truckers strike). However, if such an event occurs then the clause should take care of adequate risk cover. 

It is also important to understand the difference between a fortuitous event and force majeure. The former is what we would strictly describe as an “act of God” while the latter connotes the participation of human beings. A good force majeure clause would also allocate a period of time when the event continues before calling it quits. This allows the customer to exit the contract and have the option to search for alternative suppliers. This could be useful in a limited force majeure where the situation only affects a specific location. What is permitted to be a force majeure event or circumstance can be the source of much controversy in the negotiation of a commodity contract and a party should generally resist any such attempt by the other party to include something that should fundamentally be a business risk of the other party. 

Published in The Economic Times

Who Really Benefits From Agri-Corporatisation?

We are often advised that corporatisation will automatically take care of ills of agriculture (e.g. low productivity, lesser influence of middlemen). But who is driving the corporatisation agenda into Indian agricultural system? Consumers? No. Producers? No. 

The government’s primary economic function is to maintain competition. Instead, the top priority of the government has become to promote economic growth. Corporate interests have entered every aspect of agriculture — from the making (influencing) of laws to the delivery of basic public services. The corporations have gained so much influence in certain machinery of the government that not only does it fail to ensure competition; government at times has become a tool for corporate exploitation of both people and resources.

 
To cite the example of Bihar in maize: In December 2009-10, the state had to step in with distributed assistance to farmers. The state exchequer had to take on an extra burden of 61 crores, which it had to pay as compensation to farmers using private hybrids, on account of “non-formation of grain”. This is the first time a chief minister has dared to expose a large body corporate that in connivance with GEAC (Genetic Engineering Approval Committee) & ICAR began trials even before the environment ministry’s clearance. 

On the other hand, the “so called” success of BT Cotton in the states like Gujarat has been over emphasized by the political class. In the interlocked agricultural market, if individual commission agents at times have hijacked the chain in past on delivery side, it is more likely that institutionalised middleman with their stranglehold over the ability to influence policymaking will prove to be a curse both on supply and delivery side. 

As a consequence of farm politics, some commodities are more heavily subsidised than others. Majority of all food/farm subsidies goes to wheat, rice, sugar and that too in limited pockets of a few states. 

All over the world, some of the most blatant conflicts of interest in politics have occurred among politicians and others who serve in important agricultural policymaking positions and has substantial interest in doling out the subsidy baggages to the pockets of influence. They put the economic interests of corporate lobbyists ahead of the public interests of society in general. In certain cases, these influential persons have also become business partners of the corporate.

Past experience shows that big food retail has neither benefited the farmer nor the consumer. Contrary to popular belief, the big retail has not helped in creating jobs either. If the supermarkets were so efficient for the farm economy then why is the US providing massive subsidy to its farmers? 

In corporatised food value chain, the individual nutritional (protein, carbohydrate, vitamin etc.) components are highlighted over balanced diet (dal, roti & subzi). Problems of obesity, diabetes, hypertension, heart problems, and food-related cancers have become epidemic with growing corporate control of the US food system. Let us protect India from these. 

Published in The Economic Times

Does Branding Add Any Value to Bottomline of Commodity Cos?

Globalisation in the last two decades, along with the lowering of trade and investment barriers, advances in telecommunication and transportation technologies, has given rise to a faster price discovery of commodities. Hence, price wars have increased and profit margins have declined for commodity companies. In commodities like edible oil, wheat flour, basmati rice, milk and spices, a large number of companies are trying to beat the price trap of the commodity market through branding. Access to information (price, demand-supply and arrivals) has made it difficult for information arbitrage to remain for long on a sustained basis. Commodity-based sourcing advantages are narrowing which make it harder for companies to extract a price premium in most markets.

Just about every company is engaged in differentiation through branding. Edible oil companies can be seen often propagating virtues of good health through expensive advertisements (though doctors may suggest to the contrary). But, very few of them feel that continuous differentiation is a solution. They simply don’t get the results that they expect because everyone else is doing a similar thing. In some cases, the gestation time is long to break even with high brand-spend. This raises a fundamental question: does branding add any value to the bottomline of commodity companies?

The branding of commodities started in 1983 with the Tatas lending their name to salt to create product differentiation and to take advantages of a premium pricing in a commoditised product line. However, what difference does this make by branding commoditised petroleum products from IOC (Xtra), BP (Speed), HP or IBP? All brands of petrol (gasoline) and diesel are derived from same crude and in India it is sometimes from the same refinery (distributed through swap trades). Petrol and diesel retail prices remain regulated (irrespective of brands). Crores of rupees have been spent on the branding of the petroleum products. What value does it really add to the companies?

Companies are trying to sustain competitive advantage through product differentiation by highlighting unique features and benefits which are valued by retail buyers. In the bulk commodity world, the buyer’s perception has remained unchanged: It is price, price and price. This very “price trap” is where a company sees its competitive position being eroded so that it can no longer command a premium price in its market. In a price trap, buyers receive more product benefits for their money or pay lower prices for the same or lower levels of benefits. The result is that companies find that they can hold their prices and lose market share or they can hold market share only by lowering prices. In either case, the companies have lost their pricing power.

While many companies take commodity management as a core competency, almost all have experienced squeezed profit margins whether input costs rise or remain stable. Over time, product supplies become indistinguishable from others in the commodity market and consumers buy on price alone. 

Published in The Economic Times

Radiation Processed Food: A Big Challenge & Opportunity

‘Radioactive food’ can send a chill down to anyone’s spine. The accident at the Chernobyl (Ukraine) nuclear power station occurred on April 26, 1986. Thereafter, radioactive fallout has shown up in food commodities in various countries. The nuclear crisis at Fukushima Daiichi Nuclear Power Plant in Japan has caused a fresh scare.

There is radioactivity (manmade and natural) in all food commodities. The common radionuclides in food are potassium, radium and uranium. The world is covered in cesium-137 from the atomic weapons tests of the ‘50s and ‘60s. It’s really a matter of saying how much? 

While “nuclear dual use” is a term that is often used for peaceful or military aims, in case of food chain it could be a choice between destruction and preservation. While contaminated food with radioactive material can create havoc, radiation processing (called irradiation) of the food involves a controlled application of energy from ionizing radiations for food preservation. 

In natural conditions during sun drying, a large number of commodities get heavily contaminated with microbes including pathogenic bacteria from deposition of excreta of insects, birds, rodents and other animals and from windblown dust containing these microbes. It can also lead to caking and spoilage. Insect infestation is another major problem in stored commodities often resulting in losses up to 20-25%. All these can be controlled through irradiation which is a far superior technology than chemical preservation. It works by disrupting the biological processes that lead to decay without compromising on the nutritional and health factors. 

In countries like France, Netherlands, South Africa, US, Thailand and China, commercial quantities of some radiation processed food items — strawberries, mango, banana, shrimp, chicken, spices — are sold on the market shelf. These radiation processed food items are labelled to indicate the treatment and its purpose. 

The WHO has established limits that serve as guidelines for governments. Radioactive material in food is measured in Becquerels (Bq). The limit for iodine-131 is 55 Bq per kilogram for infant food and 300 Bq per kilogram for other foods. For meat and poultry the limit is 55 Bq per kilogram. The limit for cesium-134 and cesium-137 for all food items is 370 Bq per kilogram. 

After the Fukishama nuclear plant leak, the Food Safety and Standards Authority of India in an order has instructed its units at ports to ensure that sample tests are conducted to the products shipped out of Japan after March 11. Initially, three BRIT/BARC laboratories at Trombay (Mumbai), Kolkata and Kalpakkam were accredited to conduct test and certification for radioactivity in the food samples sent to them. By a recent notification two more private labs in Delhi & Chennai have been accredited by AERB (Atomic Energy Regulatory Board) to conduct such tests.

In case of nuclear leaks, what really happens is that the radioactive iodine from food and air can build up in the thyroid, leading to thyroid cancer years later. Radioactive iodine decays quickly, with a half-life of eight days, meaning the length of time it takes for half of it to break down harmlessly. Young children and pregnant women could be at greatest risk. The other element, radioactive cesium can build up throughout the body and is harder to eliminate and high levels are thought to be a risk for various cancers. Cesium can stay in the soil for 30 years, however the radiation stays only in the top inches of soil, so deep plowing can make a field safe to use.

Controlling radioactive leakage (contaminated with radionuclides) after a nuclear disaster is a challenge for many nations; on the other hand “irradiation” opens up new vistas in food commodity preservation. 

Published in The Economic Times

Producers’ Companies Can be a Strong Alternative to APMCs

In spite of all the criticism against Agricultural Produce and Market Committees (APMC) and accusations that middlemen have benefitted more than farmers, it is indisputable that the system has survived and grown in the last 50 years. Like many other institutions, here too the solution lies in efficient management of available resources and a forward-looking human resource that manages the functioning. A visit to some of the APMC yards will illustrate that all is not bad.

Often, APMCs are elected/nominated bodies where the governance structure and the management (operating structures) are merged by design. The expectation is that elected members are supposed to hold an “honorary position” yet devote their full time to the management of the market. This often affects the behavioural pattern of the elected body and some of them try to look at other avenues of income. If some of the APMCs in India have survived in pockets and are flourishing efficiently, then the problem certainly lies in execution failure.

The APMC was initially designed to regulate the local agricultural market with an assumption that this will automatically benefit the primary producers. In the current context, regulation is no more a priority but market efficiency with least hassle is the primary objective. Corporate forays, in all their dynamism, in spot market buying (in any particular geography) have not survived more than two years (though lots of case studies have been written).

As an alternative, if benefits have to accrue to the primary producers, then one needs a producers’ company (different from a co-operative). An amendment to this effect has already taken in the Companies Act on February 6, 2002. Therefore, one cannot dismiss the possibility of the creation of ‘producer companies’ as a utopian concept. Primarily, two functions can be ascribed to the producers’ companies: aggregation of local produce (leveraging on local mandi infrastructure) and information dissemination. It is undeniable that order and modernisation can only be enhanced through primary producers’ participation in a commercial entity where shareholder objectives are not conflicting. Moreover, innovative use of IT can provide better transparency and accountability at a local level.

The producers’ companies can have an elected board separated from the management. The appointment of merit-based professional managers will provide these producers’ companies with a better chance of success. The entire shareholding in such a company should be with the primary producers and producer organisation. The voting rights should be based on the amount of produce sold through the company rather than the number of shares held by individual shareholders. This will bring more transactions within the ambit of genuine transaction and discourage systemic evasion.

Member shareholders will initially receive only such value for the produce or products pooled and supplied as the directors may determine. The withheld amount may be disbursed later either in cash or in kind or by allotment of equity shares. The possibility that these producers’ companies entering into contracts with the entities having large raw material requirement will also protect the producers with the benefits of collective bargaining. On the other hand, it will also provide a low transaction cost for user companies. Middlemen can also be assimilated within the system by appointing them as redistributors for the producers’ companies.

Corporates can forget the ‘farmgate to fork’ dreams and focus better on the functions where they have competitive edge such as branding, retail packaging and distribution. This will compress the learning cost curve and help them in a focussed approach on areas of strength. In times of growing lobbying for a review of APMC Acts of the states in the name of ‘market modernisation’, producers’ companies can provide a strong alternative to protect the interest of the primary producers. 

Published in The Economic Times

Poor Infrastructure Behind Escalation of Logistics Costs

Physical commodities require efficient management of sourcing and deliveries (seaborne as well as land-based) for profit maximisation. The logistical costs fluctuate between 3% and 10% of the price for the commodity in trade and may reach 15% for some specialised products. 

While delivery and sourcing time have been reduced significantly over the last few years, the logistical cost is one of the key determinants affecting the movement of commodities from an underpriced origin to an overpriced destination. Inadequate infrastructure (transport & storage) causes escalation of logistical costs (which must be identified and kept under control) as the size of logistical investments is more or less concentrated. To illustrate an example, though Bihar wheat was cheaper during last year’s wheat arrival season, private flour millers of western India were buying wheat from other origins. The reason: the rake availability compared to other origins was poor and the possibility of road movement of wheat made the landed price more expensive. One must also consider that warehousing facility in the state is inadequate.

In the global trade scenario, the expertise and ability to manage movement of commodities determines the scale and profitability of business. While there is a continuous need to compress the cost and time factors, it is always a balancing act between these two. The bulk commodity trade operates on a realistic margin of not more than 1.5% and therefore the compression of logistical cost often is a cause of make or break for the traders. As a result, service providers are sometimes subjected to claims in a falling market. 

It is not only the logistical cost at the point of origination but also the distribution cost at the point of consumption which determines the movement of traded commodities. The insight of logistics within the commodity supply chain is embedded in a framework of twin structures and geographical cost advantage. 

Two dominant type of structures have evolved in commodity supply chain management systems. First, producer-driven chains which are basically propagated by companies with large skill sets in production. These dominant powerful companies in order to garner profits, operate typically in capital-intensive industries, where low-profit activities are outsourced to upstream networks of entities competing to supply raw materials and logistical services. 

Second is the buyer-driven chains in which ultimate organisational power lies with the retailers and brand-name merchandisers who coordinate often dispersed networks of independent and quasiindependent manufacturers or other suppliers and logistics service providers. Buyer-driven chains (for example, supermarket chains) are believed to becoming the dominant type in emerging economies and are found widely in consumer goods industries with low barriers to entry such as clothing,and packaged food products. In such chains, producers have become subordinate to organisations controlling design and marketing, brand names and retail shelf space. 

For a long time, logistics in commodity trade was considered a juxtaposition of operational activities. Since the beginning of the 80’s, it has been structured at an economical scale by various skills specialists in storing, shipping, rake and roadways movement. The growing distances between supply chain actors in international supply chains have led to super specialisation in each execution function where more than the cost compression objectives, corporations with large commodity exposures are trying to have a low fixed cost in a scenario of high variable logistical cost. 

Published in The Economic Times

Warehouse Receipt Recognition to Help Lenders & Borrowers

Pledge financing in commodity trade is not new to India. It had been in practice for the last three decades. However, it got a new lease of life due to emergence of collateral management companies in the middle of the last decade. The grassroots servicing was ensured through fee-based structures. The market meltdown in 2008-09 impacted increasing operational concerns in commodity financing and thereby raised the importance of monitoring commodities as security.

Physical availability of commodities assures not only that the advances are adequately collateralised but also the proceeds of the advances are properly utilised by the customer to purchase or process the commodities. Security of commodities can be ensured in two ways by the lenders: pledges or by way of ownership. Ownership or title to a commodity as a means of security is theoretically the best option for a lender. Yet, often banks prefer that their customers own the goods, given the responsibility and costs that ownership can sometimes involve. On the other hand, a pledge involves the delivery of possession of goods as security until payment. So, creation of the pledge involves two parts: the transfer of possession and the intention to pledge. In addition, the borrower must retain ownership of the goods. 

Two terminologies in the context need to be clarified: ‘constructive possession’ and ‘possessory pledge’. Constructive possession (often relevant with context to the collateral management) is a term to describe a situation where an individual has actual control over commodity without actually having physical control of the same assets. At law, a person with constructive possession stands in the same legal position as a person with actual possession. The other terminology ‘possessory pledge’ is much easier to deal with security given in the form of a possessory pledge as the identity of the collateral is incontestable and the intention of the borrower to pledge the collateral is clear, avoiding disputes as to ownership and competing claims. When the commodity is stored in a remote location or in many locations, third party control allows a borrower to utilise inventory collateral efficiently as a basis for advances. To assure that physical availability, the role of the collateral manager becomes all the more important. 

In certain cases, field warehousing (where instead of moving the goods to the warehouse; the warehouse is moved to the goods) the lender and the borrower enjoy the benefits of warehouse receipt financing. In doing so, the possessory pledge is converted to a relatively convenient and cost-effective form of security with a much higher degree of legal protection and practical control than is afforded by a registered charge or security interest. Warehouse receipts are often assumed to be a document of title similar to a bill of lading. Therefore, warehouse receipts are one way in which rights of constructive possession may be given to a pledgee. This is because Warehouse receipts are viewed as documents of title, the transfer of which can transfer ownership of the goods themselves. 

The laws relating to documents of title to goods held by recognised bailees and the rights of good faith purchasers and encumbrances holding such documents are maturing in India. In the next few years, WHR recognition will provide a powerful tool for lenders to lend and borrowers to maximise the collateral value of the commodities. 

Published in The Economic Times