Challenges to developing forward contracts
There are a number of risks and challenges to creating and sustaining longer-term forward contracts beyond six months.
Geographic isolation and a relatively small domestic consumer population make WA heavily export dependent and exposed to variations in currency, trade and market access, and international logistical supply chains. Commodity forward contracts were found to be far more common in domestic markets due to lower risks and complexities in delivering product to the end customer. With over 4500 producers with sheep flocks in WA, supply chain fragmentation is also an issue.
From a processor and end-buyer perspective, there are several potential barriers to medium term forward supply arrangements and contracts including securing consistent and certain contracts with customers, the lack of a derivatives market, and guaranteeing the physical delivery quantity and quality of sheep and lambs from contracted producer suppliers.
There are a number of advantages and disadvantages of forward contract arrangements that have been identified with potential to impact on either the seller or buyer (Table 1).
| Key advantages | Key disadvantages |
| Manage risks | Reduced market flexibility |
| Remove uncertainty, building market security and confidence | Price risk assumed by processor |
| Reduce volatility for entire supply chain | Production risk for producer |
| Income stability, providing improved budgeting and financial management | Spot market price deviates from forward contract price |
| Enable infrastructure investment planning | Purchaser obtaining back to back commitments |
| Enhance productivity and efficiency value through delivery to specifications | Potential market concentration |
| Facilitate coordination among stages of production, and build value chain relationships between producer and downstream processor (aids information and data flows) | Risk of reduced competition in spot markets – greater use and adoption of forward contracts reduces the participation of buyers in spot markets (However, this is potentially offset by reduced supply in spot markets.) |
| Increase supply chain infrastructure utilisation | Loss of price information – increased use of contracting may reduce availability of publicly available pricing transparency |
| Increase confidence to grow sheep supply and assure adequate supply | Risk of not being paid |
| Improved quality control | |
| Potential alternative sources of finance and improved access to capital through income stability | |
| Reduced transaction and financial costs | |
| Intellectual property protection |
Source: various sources and industry engagement
The challenges to the development and implementation of a functional and effective medium term (six to 12 months) forward contracting supply system have been sufficiently overcome in other agricultural commodity sectors operating with and without derivative markets. Specific examples include the Australian pig and dairy industries and the growing use of short term (less than six months) physical forward contract arrangements in the beef and lamb industries in Eastern Australia.