Why index pricing is crucial for the lithium supply chain

Buyers and sellers in many markets index their long-term supply contracts to benchmark prices that are produced independently by price reporting agencies (PRAs) or on futures exchanges.

Often those markets themselves were once priced in a comparable way to the current model in lithium, in which long-term contracts were traditionally settled in bilateral negotiations at a fixed price over one or several years.

So why has the prospect of index-based pricing for the lithium market caused some producers to express reservations about contributing data to such an index, for the moment at least?

It is worth remembering that those fixed-price long-term contracts existed for a variety of reasons.

They guaranteed stability for buyer and seller for the length of the contract, at a time when the flow of information and data faced obstacles that are unimaginable today.

They enabled detailed and protracted negotiation around chemical requirements, specification and future supply and demand.

They might have supported the proposition that the product was a special material and not a commodity at all, thus acting as a potential lever for equity valuations.

But ranged against these arguments are far more compelling reasons to consider just how moving to market-based index pricing can serve whole supply chains.

(Not least of them is that those conditions can still be met, with the caveat that certainty about a fixed price is replaced by certainty about the means by which an independent, market-based price has been created.)

Fairness and efficiency, without which the long-term partnerships that lithium producers seek to establish are far harder to sustain and improve, are a good place to start.

The gyrations the lithium market has been through since the end of 2015 are emblematic of the challenges that producers, refineries and end users face.

Lithium consumers have responded to the prospect of being tied to long-term contracts fixed when the market was trading at far higher levels by looking for shorter and more flexible terms.

To avoid being locked into higher lithium prices than their competitors, and that the supply response to the earlier deficit had created, they cut commercial terms in contracts to be able to take more account of volatility. In doing so they turbocharged the spot market in China.

There are widespread expectations that spot-traded volumes will grow outside China too as well as widespread interest in prices delivered to the main ports of Japan, Korea and China as a result.

The development of that spot market has created the opportunity for the industry to adopt pricing that can be used across the supply chain to ensure that everybody is paying, or being paid, a fair market price that moves in accordance with the fundamental underlying drivers of the market.

This fairness over time is the essence of why supply chains settle larger contractual trade flows using the non-contracted, or marginal, spot tonnage, which is the point where the price is discovered when supply meets demand.

Alongside fairness and efficiency, there is an equally pressing argument from the perspective of shareholders.

Owners of equity will have the right to question the pricing strategy of lithium producers if they settle fixed prices that fall behind the spot market as the result of a deficit in years ahead, just as they might ponder what led consumers to locking in higher contract prices when markets fell.

Commodity markets can easily run to levels well beyond that forecast by analysts at a time of deficit. Negotiations based on those forecasts ahead of time are necessarily tempered by the fact that they are bilateral and self-interested.

(Buyers, that is, will look for factors that mitigate the forecast deficits. Since the future is uncertain, and customers will still be around next year, suppliers will be bound to accept those arguments, albeit to a greater or lesser degree. The converse is also true for forecast surpluses.)

The adoption of index-based pricing, whether the material behind it is considered a commodity or a specialty material, is essential to both sides of a transaction because it captures and passes on the underlying market in a fair and efficient way over time both to producers and to consumers.

Nor does the use of benchmark prices in this way preclude suppliers and their customers from negotiating discounts or premiums to the benchmark based on a comparison of specifications, further processing or other terms.

Beyond this, index pricing, underpinned by clear and transparent methodologies, means that suppliers and consumers can both focus on more substantive issues than price itself, such as partnership, research and development and the holistic opportunities and risks that any supply chain faces.

Finally, its adoption gives the whole market broader foundations from which to develop.

This is not confined to the cheaper financing that is available to companies working in financialised commodity markets or the fact from a supplier perspective that such markets tend to carry a lower discount for risk, though such factors are significant.

Most importantly, it opens the door to consumers being able to hedge their price risk and offer fixed prices to their customers in the huge companies waiting downstream to build the vehicles and energy storage systems.

And, after all, it is demand from those companies that makes the future so exciting for the whole lithium industry.

The development of pricing in the lithium market through our partnership with the LME will be a key theme of the Fastmarkets Battery Materials Europe event, taking place in Amsterdam on 26-27 September. Find out more here.