Do you work in an industry with volatile markets? Like finance or agriculture? Then you might already know long-term planning for your business can be difficult, especially when profits are so uncertain.
That’s where a little forward thinking in the form of a Forward Contract can help!
What Is A Forward Contract?
A Forward Contract is a contract to buy and sell specific assets at a certain price at a future time. Forward Contracts are usually tailored and negotiated according to the specific needs of your enterprise and the buyer.
A Forward Contract can also mean locking in a foreign exchange rate to make a monetary transfer at a future date. In this scenario, a deposit might be paid, with the benefits being a better exchange rate for the transferer, especially if the transferer thinks the exchange rate will fall.
In this article however, we’ll focus on how Forward Contracts can help suppliers of commodities, such as farmers.
Alice wants to sell two tonnes of fine merino wool to a buyer in Guangzhou in September next year.
Alice and the buyer settle on a fixed price, amount, and quality, and sign the contract 8 months in advance of the sale.
What Are The Alternatives To Forward Contracts?
For industries like agriculture, auctions (whether online or in sale yards) and on farm negotiations are common.
The benefits of alternative forms of selling are flexibility, and the ability to make more profit if markets go up.
However, if there is a lot of competition come sale time, this could of course drive profit down. For some commodities which do not store well and thus cannot be delayed, such as fresh produce, sellers are often at the whim of how much competition there is when it comes time to sell.
This can be particularly difficult for farmers, who may have little choice as to when they can produce certain products as they are climate reliant.
Prime lamb production may produce lambs that are ready for market at a very specific time, as it may be cheaper to produce lambs at a certain time of year when the weather is favourable. When lambs are ready for auction, the market is flooded with prime lambs, leading to a lower overall profit.
In comparison, farmers may be able to store and sell non perishable products such as wool at a later date, when conditions are more favourable.
Why Use Forward Contracts?
There are multiple benefits to a little preparation. Specifically in the industry of agriculture, risk is much higher than in other enterprises. Agricultural enterprises encounter the additional physical risks of climate, pest control and product storage as well as price risks of being particularly reliant on export markets (with Australia’s small domestic population), political stability, and exchange rates to name a few.
- Lower interest rates on loans:
As any business operating within a volatile market knows, getting loans for high risk activities can equal higher interest rates. By having a demonstrable profit locked in, interest rates on loans may be cheaper.
- Predictability in profit:
This reduces the risk a business has to take, as well as the time and energy needed to attend auctions and organise a buyer/s. With so many variabilities in farming or producing commodities, having some predictability can go a long way in reducing stress.
- Ability to long term plan on your enterprise:
Knowing how much profit one is expected to make, and how many commodities an enterprise must create by a certain date means production can be planned accordingly.
Being able to budget an enterprise knowing how much profit one is expected to make can also free up time and resources to plan other long term changes to the enterprise.
This makes Forward Contracts particularly attractive for larger farm enterprises
- Enhanced bargaining power:
When a farmer must sell a commodity that has an expiry date, there is less time to seek a favourable buyer, and also less bargaining power as they now have produced a certain amount of commodities they need to dispose of.
From the buyer and consumer’s point of view, Forward Contracts are a better method of being able to trace the origin of goods than being sold through traditional methods such as auction.
- Differentiation of products:
The buyer can also guarantee certain quality guidelines will be met, and that they will have a specific type of commodity.
For example, the buyer can guarantee they will have a certain amount of organic chardonnay wine produced in the Margaret Valley region without the use of pesticides.
Disadvantages To Using Forward Contracts
As Forward Contracts are usually set well in advance, there is no leeway should growing conditions change.
If conditions to produce a product become more expensive, for instance severe drought or weather, the selling price will not reflect the revised and more costly inputs for the supplier.
Mandy signs a Forward Contract to produce 2000 prime lambs in 12 months time for an agreed price. During that time however, drought strikes and destroys pastures. Mandy must now pay for supplementary feed all year, which was not factored into her initial budget.
As a result of the drought, prices of prime lambs go up, which is reflected in the auction yard. As Mandy is locked into her contract however, she must still provide her products for the previously agreed upon price.
As well as this, should markets rise, the producer is at a disadvantage as they cannot take advantage of the flexibility of a rising market.
This is why Forward Contracts may not be used so much where there is strong predicted growth in a certain market.
What Is Included In A Forward Contract?
A Forward Contract will include the following,
- The quantity of goods
- The quality standard of goods
- The time at which the sale will take place
- How disputes will be handled (for instance, in what jurisdiction and under which law should the contract be with an overseas buyer)
- Any flexibility that may be built into the contract
Forward Contracts can help your agricultural business not only reduce risk, but also allow you to make long term plans with your enterprise. Forward Contracts are thus a great way to help grow your business!
It’s important your Forward Contract is drafted by a lawyer, or if you are accepting a contract, that you have a lawyer review the contract before you agree to it.
As Sprintlaw is an online law firm, we are ideally placed to help you no matter where in the country you are!
Feel free to get in touch either at firstname.lastname@example.org or at 1800 730 617 for a free, no-obligation chat.
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