I recently came across a newsletter article with great relevance to MetalMiner readers — How to Fix Index Based Pricing — that offered up three suggestions for individuals seeking to develop a price indexing schema for purchases.
The author states a hypothesis often not articulated by the purchasing organization – having a “fixed, predictable price is just as important, or even more important than having the lowest possible price.” We’d concur with this hypothesis, based on our own experience with the statement that buying organizations have tended to ask suppliers to hold firm, for longer periods of time, the quoted price paying less attention to whether the price has reached rock bottom or not.
The author of the linked piece above goes into the case for longer fixed prices that we won’t dive into here. He also suggests three factors to consider when using indexes – choosing the right index, adding a cap (or collar, as we would say) and picking the right timing for price adjustments (the author suggests the longer the better).
Here we might consider an alternative point of view. Certainly if holding prices fixed remains paramount to all other considerations, then in our world of metals, quarterly price adjustments might indeed make perfect sense. However, we’d add a caveat to that based on market conditions.
We’d suggest that the index strategy should also take into consideration the pricing dynamics of the underlying commodity. For example, the index strategy, so to speak, may change based on whether the underlying commodity’s price has upward price momentum, downward price momentum or basically holds steady.
In a rising cost market, using an index as the author suggests makes perfect sense – “tak[ing] as much off the table as possible” can help the buying organization hold prices firm for longer. But if the underlying commodity faces downward price momentum, a longer fixed contract makes less sense even if one desires price stability.
Instead, buyers may wish to hold off on buying decisions until the last minute, taking advantage of lower prices as they drop, minimizing the risk of purchasing inventory at a higher cost. In flat markets, buying organizations can follow the practices of a rising market – taking as much off the table as possible and holding prices firm, actually modeling market conditions.
In a follow-up piece, we’ll explore how the new CME aluminum swaps contract will allow buying organizations to do just this – hold prices fixed firm for longer time periods.