Using a widely accepted reference price in physical contracts is a common practice in commodity markets, particularly in base metals. Producers and consumers often refer to globally accepted prices, such as those determined by the London Metal Exchange (LME), while also negotiating discounts and premiums based on the specific material being traded. Unlike steel markets, which historically relied on fixed prices or the spot market, the practice of using a reputable reference price separate from premium costs offers advantages like transparency, efficiency, and optionality.
One of the key benefits of linking physical contracts to a reference price is the increased transparency provided by organizations like the LME or price reporting agencies (PRAs). In a complex global economy, it becomes challenging for companies to consistently outperform the market. By agreeing to trade at the market price reported by reputable sources, companies gain a clearer understanding of market trends. This allows them to focus their negotiation efforts on determining the value of premiums or discounts based on factors like geographical location, material grade, impurities, and delivery terms.
The LME serves as a regulated trading venue for price discovery, providing companies that refer to its prices with the advantage of knowing the market's current state. This eliminates the need for extensive resources to gather information for independent market price discovery. PRAs also play a similar role by offering indices that serve as price references. By utilizing accepted prices, companies can efficiently refer to the market price defined by the LME's contracts or the PRAs' indices for the underlying metal.
Furthermore, referring to globally accepted prices, such as those provided by the LME, gives companies the flexibility to hedge their exposure to the price of the underlying metal without basis risk. By participating in standardized and liquid markets, companies can make informed decisions, choosing to lock in prices or float them based on their risk appetite, future projections, and the shape of the forward curve. However, companies are still exposed to premiums and discounts that are specific to the material being traded, as these factors are highly specific and not easily tradable in the market due to lack of standardization and liquidity.
Let's consider the use of LME reference prices in physical copper contracts as an example. The LME Official Price for copper is determined daily based on bid and offer prices during the second morning Ring trading session. This Official Settlement Price is extensively used in physical copper contracts worldwide. It represents the price of any approved LME brand of copper available for delivery within the LME's global warehouse network in two working days. Once established, the LME records, distributes, and publishes the price to vendors and industry users across the value chain.
Throughout the copper industry pipeline, the LME Official Settlement price is utilized in various ways. For instance, copper producers reference the cash seller price in their contracts, allowing for the price differential between the ore and the LME grade of underlying metal (Grade A copper cathode). As the metal progresses along the supply chain, moving from copper semi-fabrication to the final use in products like copper wire, the material is priced at a discount to the LME Official Price until the value of fabrication becomes more significant. At this stage, a premium is applied. The proportion of the LME Official Price used in contracts depends on the percentage of the product's value attributable to the underlying copper metal.