The risks associated with extracting resources are high, and one way exploration companies can reduce these risks is by making offtake agreements. But what are these agreements and how do they work?
An offtake agreement is essentially a deal between a company that produces a particular resource and a company that needs to buy that resource. It formalizes the buyer’s intention to purchase a certain amount of the producer’s future output.
Here’s a brief overview of the importance of offtake agreements in the resource sector and how these deals work.
Why are offtake agreements important?
Offtake agreements are important for many companies, but are particularly crucial for those focused on critical and industrial metals. Many of these metals are not sold on the open market, and that makes it harder for producers to offload them.
Generally, offtake agreements are negotiated prior to mine construction; they help assure producers that there is indeed a market for the material they plan to produce. That is beneficial for a number of reasons — most obviously, it means the company won’t have to worry about being able to sell the metal it produces.
Additionally, having an offtake agreement tends to make it easier for producers to secure the necessary financing to move forward with mine construction. Lenders and investors are more likely to have confidence in a project if they know that companies are already lining up to buy the metal it will produce.
Buyers will also sometimes provide producers with money to advance their projects when an offtake agreement is created. However, that is not always the case.
Of course, offtake agreements can also be beneficial for buyers. Offtake agreements allow buyers to purchase metal at a particular price. This can function as a hedge against future price changes if demand outweighs supply. Offtake agreements also guarantee that buyers will receive the product they are purchasing at a specific date.
Offtake agreements step by step
Still confused? Here’s simple breakdown of how offtake agreements work:
- Let’s say a company has been working on a new coffee mug, but is looking for financing to develop this new project before it is actually produced.
- In order to ensure financing, the company signs an offtake agreement with a coffee shop that is interested in selling the mugs once they are produced. In this agreement, the coffee shop agrees to buy all the mugs produced during the next year.
- The mug producer can assure investors and lenders that there is a market for its product before it begins production. It can also be confident knowing that it has ensured a minimum return on its goods.
- The coffee shop can continue functioning as normal because it knows that it has secured a supply of mugs for a particular price and for delivery at a particular date.
Offtake agreement risks
While offtake agreements have many benefits for both producers and buyers, it’s important to note that there are risks associated with them as well.
It’s possible for both parties to back out of an offtake agreement, though doing so requires negotiations and often the payment of a fee. Companies also face the risk of not having their offtake agreements renewed once they are in production — and they usually must make sure that their product continues to meet the buyer’s standards.
Offtake agreements can also be complicated and can take a long time to set up. For companies that want to move forward with their projects quickly spending that time can be a hindrance.
This is an updated version of an article published by the Investing News Network in 2011.
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Securities Disclosure: I, Sivansh Padhy, hold no direct investment interest in any company mentioned in this article.