Offtake Agreement Meaning
An offtake agreement (OT) is a long-term legal contract between two parties wherein the buyer undertakes to buy all or some portion of the manufacturer’s future production. It is usually entered upon before setting up the production unit so as to facilitate project financing. Such agreements are widely prevalent in mining, oil and gas exploration, and agriculture.
An Offtake agreement is an agreement between the buyer (off-taker) and the seller to purchase or sell goods i advance, even before production starts.
The main objective of the offtake agreement is to enable the producer to obtain easy finance and a guaranteed buyer for its future products. This type of agreement benefits both the buyer and the seller alike. While the seller has an assured market for its creation, at the same time the buyer enjoys protection against future price rises and supply shortages. There are different types of OT agreements based on the needs of the parties to contract.
Key Takeaways
- An offtake agreement is an agreement between the buyer (off-taker) and the seller to trade goods prior to their production.
- It is typically used for natural resources development projects requiring huge capital investment like mining, oil and gas extraction, power generation, etc.
- Offtake agreements enable contracting parties to manage future risks and obtain finance readily.
- Some important types of offtake agreements are Take or Pay, Take and Pay, Blended, Long Term Sales, Hedging, and Power Purchase Agreements.
Offtake Agreement Explained
An offtake agreement is a way to secure the parties to contract before the commencement of production. It ensures that the seller gets a fixed buyer and the buyer gets the desired product at a fixed price. This OT agreement is common in capital-intensive projects like infrastructure development, roadways, real estate, logistics, and agriculture-related manufacturing sectors.
Since such projects require a large capital investment, companies need a security buffer like an OT agreement. It ensures the supply of funds and buyers for their products. However, any company can enter into such a deal beforehand to secure its position in the future.
An OT agreement indicates the price and specifications of the future products, along with details related to their delivery. It also defines the rights and duties of the buyer and the seller. Once the deal finalizes, the manufacturer can show it to investors or lenders to obtain a loan easily.
With a credible buyer and a secured stream of future cash inflows, financiers are also keen on funding such projects as they are certain of recovering their dues. Moreover, it also assures the buyer of receiving supplies in the future without fail at an agreed rate. So, it is a win-win situation for everyone.
However, OT agreements are not totally risk-proof as there is always a possibility of breach or termination of the contract. Usually, the contract contains a Force Majeure clause related to the termination of the contract in case of extreme circumstances like insolvency, natural disaster, etc. In case of breach of contract, the parties have the option to renegotiate and continue the contract.
How does the agreement relate to the offtake function?
Let us first understand the concept using a simple illustration. Suppose AHC is a company working to develop a unique health monitoring app for Apple Inc. But the app development project requires a lot of financing to deploy app developers, testers, testing facilities, servers, and other requirements. However, AHC does not have the funds to fulfill the app development.
Therefore, AHC reaches out to Apple Inc. and tries to reach an agreement to fund the app development. Hence, Apple Inc. agrees to buy the app in the future and signs an offtake agreement with AHC. Thus, AHC can use this agreement to secure bank loans and funding. Furthermore, Apple Inc. will receive the app at the agreed rate after its development.
Types of Offtake Agreement
In addition to these, there are seven major types of offtake agreements in practice within project finance. They are executed as per the requirements of the manufacturer or buyer. Let us discuss each one of them here:
- Take or Pay Contract: It is an agreement between seller and buyer that protects the seller’s interests in case the buyer refuses to buy the products. This type of OT agreement requires the buyer to make the payment unconditionally. For example, during 1950-60, several promotional pipelines were funded through the take or pay contracts.
- Take and Pay Contract: This type of OT agreement is entered between buyer and seller on the condition that the buyer will pay the seller only if the product is delivered.
- Blended Contract: It is a hybrid of the Take or Pay Contract and the Take and Pay Contract. Under this contract, the payment by the buyer is in terms of advance loans to the seller. The seller repays by providing appropriate valued goods or services.
- Long-Term Sales Contract: Such contracts are used for products like oil, gas, mining, and petrochemical, which have readily available buyers. They are usually for 1 to 5 years. Under such a contract, the project company agrees with the off-taker to sell its product at prevailing market rates. However, the buyer will have to pay appropriate damages if it does not buy the product from the project company.
- Hedging Contract: This agreement is done to safeguard the project company from variations in product prices. The company keeps the price bracket of the product between the maximum and minimum of the market prices while getting into an agreement with the off-taker company.
- Throughput Agreement: It is specifically related to petroleum or oil refinery finance. Under this agreement, the project company must ensure the supply of a minimum amount of product at an agreed rate to the pipeline operator. This helps the operator to maintain the operational expenses and meet its debt burden.
- Power Purchase Agreements: This type of offset agreement is prevalent in electricity-generating projects. Here the government acts as an off-taker to buy the power.
Frequently Asked Questions (FAQs)
What are the risks of an Offtake agreement for the seller and manufacturer?
Offtake agreements are quite time-consuming and lengthy. Both the project company and off-taker face the risk of non-renewal of the agreement after the production commences. It becomes difficult for both parties to consider the quality of products during the creation of an offtake agreement. Then, there is the possibility of a breach or termination of the contract.
Why is it important?
Offtake agreement has become quite indispensable for the global economy. It is a prerequisite for financing huge capital-intensive projects like oil and gas exploration, space exploration, aviation, infrastructure, etc. This is because it offers a guarantee of returns.