Saturday, February 8, 2020

Rare events, force majeure, and coronavirus

The impact of the coronavirus on the global economy may be deeper than thought. New reports are showing that commodity market may be affected as some buyers are invoking force majeure contract provisions to get out of obligations for delivery. In this case, the coronavirus is being viewed as an "act of God" and is covered by this contract feature. A force majeure provision should be specific but exists to cover rare events that will have high economic impact, a tail event. These events can subjective because the contract may cover events that have never occurred and a poorer economic environment my itself may not be a force majeure event.

A Chinese natural gas (LNG) buyer and copper importer have invoked this clause and will not take delivery of commodities. There are reports that close to 50 LNG cargoes may be affected. There are also reports of a desire by some commodity importers to slow deliveries. 

The actions of one may actually lead to run on the bank problem as others start to invoke the force majeure provision. This will cause global logistic problems and create a greater likelihood of steeper commodity market contango. 

The supply chain is the front-line of any economic slowdown and the most likely place to see the impact of a demand shock. Financial markets have reacted to the virus, but the there is a discounting of longer-term cash flows. Reneging of commodity contracts places supply directly into markets.  Coupled with a warm winter, natural gas has been in a deep fall since November. Copper prices have been hit with a virus effect because the quarantines have led to a clear economic slowdown.

Can force majeure be priced? The problem is that both parties may have subjective expectations which cannot be quantified, but it has value since parties will require this language provision. There is clear optionality with a provision that allows a party to walk away from the contract and as the economic environment has increased in uncertainty and volatility has moved higher, the value of this provision has increased. 

Contract provisions that have been given little thought may actually create a feedback loop that will spillover to global markets. Further weakening in commodity market will also affect credit markets and firm viability for mining and energy firms. The coronavirus is contagious in ways that are often unexpected.

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