The ‘Price Majeure’ Clause
Some Chinese traders are essentially treating commodity contracts as one-sided call options, which is heightening counterparty risk and whipsawing prices in some markets. This phenomenon is tough to police or otherwise account for:
When a commodities company reneges on a contract because of reasons beyond its control — so-called acts of God, such as a hurricane — they invoke “force majeure,” a clause that allows them to walk away from a deal legally. When a Chinese trader reneges on a contract because the price has moved against it, he just simply walks away — illegally. Western traders joke that their Chinese counterparts invoke an imaginary “price majeure” clause. Right now, iron ore, thermal coal and coking coal deals are witnessing a large number of “price majeure” cases which are exacerbating the drop in benchmark prices of those commodities.
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Chinese “price majeure” is important in understanding the current slide in prices and to gauge not only the true health of the iron ore and coking coal markets, but also of natural resources equities.
The mechanism is easy. As soon as spot prices drop, Chinese traders locked into more expensive contracts have an incentive to default, and to buy the commodity cheaper in the spot market. As such, the defaults do not indicate a massive slump in demand — although consumption needs to be weak for the problem to emerge in the first place.
The sequence is as follows: benchmark prices drop in the spot market; Chinese buyers walk away from contracts, often at the last minute; suppliers are forced to dump their defaulted-cargos in the spot market at knock down prices, further depressing the spot market; this triggers a fresh round of Chinese defaults. The spiral feeds itself, producing dramatic price corrections.
There is no doubt demand is weak in China, but current price falls are exacerbated by the defaults, which in turn are exaggerating the effects of the drop in consumption.