Pre-Export Finance in Commodities

An important tool for cash strapped producers

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At first glance, the commodity business appears simple. Producers explore for commodity reserves, they then extract those reserves, process them into standardized raw materials and sell them on the international market. These staples are then available to consumers all over the world. This explanation only works in a perfect world.

A problem arises because many times commodity resources are present in countries that do not have the financial wherewithal to pay for the production process.

 Consider the fact that the majority of cocoa production in the world comes from poor West African countries, the Ivory Coast and Ghana produce some 60% of the world's annual supply of cocoa beans. Even a commodity like oil, is often produced in countries that are financially stressed. Venezuela, Nigeria, Algeria and other poor nations are major producers of oil. These examples underscore how countries that have major reserves of important commodities demanded by the rest of the world do not have the cash financing available to bring production to market. This is why banks, trading companies and investors often stand in between producers and consumers to finance the production of raw materials. These entities become intermediaries- they make production possible. The mechanism they provide to producers is pre-export finance.

There are two types of pre-export finance transactions: a fixed price and floating price-financing arrangement.

While these transactions can become very complicated and often require huge legal agreements, the idea is simple. An intermediary provides the cash necessary to extract, process and bring the commodity to market and the producer pays a fee and in many cases promises to sell the output directly to the financier.

Fixed Price Pre-Export Finance

In a fixed price pre-export finance transaction the producer promises to deliver a commodity to the financier at a fixed price on a specific date in the future. When I worked for a major commodity trading company in London in the late 1980s, I entered into this type of financing arrangement with the Russians. The Russians produced nickel in Siberia at Norilsk Nickel. The Russians were constantly cash-strapped. In order to buy nickel from Norilsk a buyer needed to pay up front for metal delivered on a future date. As Russia was a considerable credit risk in those days, my company was only willing to take Russian credit risk for 3-month periods at a time. Therefore, I would buy nickel from the Russians for delivery in 3-months and pay a fixed price, up front for the promise of delivery. I locked-in the price of the nickel by selling it on a forward basis on the London Metal Exchange (LME). This removed the market price risk from the transaction. All that remained was the delivery risk. If delivery of the metal did not take place, mark to market price risk against my LME hedge became a consideration as well. My profit margin was the difference between where I bought from the Russians, the cost of borrowing money for a 90-day period so that I could pay them upfront and the price I was able to sell the nickel at on the LME.

This was a very profitable business, so long as the Russians fulfilled their obligation to deliver the nickel. This transaction provided the Russians with both financing and a hedge or locked-in forward price for their nickel.

This is an example of a fixed price pre-export financing transaction.

Floating Price Pre-Export Finance

A floating price pre-export finance transaction is almost the same as the fixed price. The financier pays cash to the producer upfront to finance production of the commodity. However, the difference in a floating price transaction is that there is no agreement on the final price for the commodity until actual delivery. Price risk remains with the producer and credit risk is entirely with the financier.

The parties- the financier and the producer, negotiate the terms of all pre-export financing transactions.

These are not standardized deals like typical futures contracts. They are principle-to-principle deals where each party has credit and/or market price exposure to the other. Both parties often require all sorts of legal clauses protecting them from different eventualities. Pre-export financing transactions are the only way that some producers have the ability to extract resources that they control.