The risks associated with extracting resources are high. One way exploration companies can reduce these risks is by securing offtake agreements. But what are they, and how do they work?
An offtake agreement is essentially a binding contract 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 it works when companies enter into these deals.
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 after a feasibility study is completed and prior to mine construction; they help assure producers that there is a market for the material they plan to produce. That is beneficial for a number of reasons — most obviously, it means the mining company won’t have to worry about being able to sell its metal.
Additionally, having an offtake agreement tends to make it easier for producers to secure financing to move a project through mine construction. A lender or investor is more likely to finance a project if they are confident that companies are already lining up to buy the tonnes of metal it will produce.
Buyers will also sometimes provide producers with money to advance their mining projects when an offtake agreement is created. However, that is not always the case.
Of course, this type of contract can also be beneficial for buyers. Offtake agreements allow buyers to purchase metal production at a particular market price. This can function as a hedge against future price changes if demand outweighs supply. The terms and conditions of an offtake agreement also guarantee that buyers will receive the tonnes of product they are purchasing at a specific date.
Offtake agreements step by step
Still confused? Here’s a 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. Under the terms and conditions of this contract, the coffee shop agrees to buy all the future production of mugs that the company intends to produce 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 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 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 usually 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 mining companies that want to move forward quickly with project development, spending that time can be a hindrance. These companies may choose to progress on their own and discover other routes to project financing.
This is an updated version of an article published by the Investing News Network in 2011.
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Securities Disclosure: I, Melissa Pistilli, hold no direct investment interest in any company mentioned in this article.
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