COVID-19 and LNG supply commitments
COVID-19 is continuing to have a crippling effect on the LNG industry across the globe. Oversupply, a collapse in demand and lack of storage availability have devastated the market, as prices collapsed to record lows.
The current gas glut raises concerns for buyers under long-term LNG contracts that go beyond pricing alone but also affect volumes of cargoes due under typical take-or-pay obligations, whereby the buyer is required to pay for a minimum quantity of natural gas and accept delivery or pay the corresponding price regardless of whether it accepts delivery.
These far-reaching effects of COVID-19 raise the question of whether price review can be triggered on the grounds of force majeure or substantial change in economic circumstances.
Maltese courts have on several occasions established that exemption from liability on the grounds of force majeure requires the defaulting party to prove that the default was due to an obstacle that was simultaneously unpredictable, external and unavoidable and that the event rendered performance of the obligation impossible.
Under English law doctrine it has been frequently established that a change in market or economic circumstances, no matter how extreme, would not generally result in contracts being annulled or adjusted on the grounds of irresistible force.
Although it is unlikely that force majeure will be accepted on the grounds of economic and market circumstances, force majeure notices and the risk of arbitration have been invoked by buyers in recent weeks and months as bargaining chips in their attempts to renegotiate existing contracts worldwide. One example is China’s largest LNG importer, CNOOC, which claimed force majeure on cargoes due, in a unilateral action that has other market players mulling their force majeure options.
A more flexible legal doctrine to force majeure that is commonly raised is that of changed circumstances. This doctrine has been frequently raised with success before the Maltese courts and Maltese Arbitration Tribunal, citing spikes in the price of oil that impacted the profitability of public roadworks, a situation reminiscent of COVID-19, albeit in the inverse scenario.
On the continent, German gas suppliers successfully raised such grounds in price revisions during the 2012 gas glut. The provisions of the German Civil Code were raised, stipulating that where circumstances have changed since the contract was entered, to such an extent that the parties would not have entered into the contact (or would have only entered subject to adjustment), then the parties cannot be reasonably expected to uphold the contract without alteration.
The doctrine of changed circumstances is frequently included in LNG supply contracts through hardship clauses
The doctrine of changed circumstances is frequently included in LNG supply contracts through hardship clauses, to address a breach of the commercial limit of sacrifice. Hardship clauses are distinct from force majeure in that hardship, while external and unforeseeable, does not make performance of the contract obligations impossible, but its intention is to maintain economic equilibrium through re-negotiation of the economic balance of the contract.
Hardship clauses alone are, however, frequently unsuccessful in leading to price re-negotiation. Accordingly, a standard feature of LNG long-term purchase contracts is the inclusion of what is referred to as ‘kink points’, whereby the purchase price will fluctuate within an agreed band with a maximum ceiling and floor price.
Such clauses are typically inserted to cater for extreme market pricing and avoid situations of contract re-negotiation, disputes or breach of contract. This ensures that the LNG purchase price is permitted to fluctuate within acceptable limits that consider the cost of capital for project developers and the expectations of buyers.
In addition to the above, long-term LNG contracts will generally include price re-opener provisions allowing for price review to take place every three to four years. Such clauses recognise that the economic conditions under which the parties conduct their business may change during the duration of the contract and provide for the possibility of price review following significant market disruption.
Price re-opener clauses typically providing for good faith discussions between the parties and if the parties fail to reach agreement, negotiations will be followed by arbitration, and in some instances, termination of contract.
In terms of Malta’s gas supply agreements, it does not appear that the global gas glut has impacted pre-existing contractual arrangements.
While Malta’s LNG purchase contracts have not been publicly disclosed, from the information available it is understood that Malta’s LNG purchase commitments apply over a period of 10 years, with purchase commitments for the period 2017-2022 fixed at a price of $11.50 per mmbtu, while the remaining five-year period would move to market linked prices indexed at 14 per cent of the price of Brent Crude. Such pricing arrangements were already deemed to be at the high end in 2017 but are unheard of in today’s market environment.
Where the LNG price is fixed, severe market disruption leads to a one-sided scenario, where a sale and purchase contract may no longer reflect what was reasonably expected at the time it was entered into.
The fixed pricing method utilised in Malta’s LNG supply commitments has given rise to such a one-sided scenario, and it would be interesting to know the extent to which stabilisation clauses have been included in Malta’s LNG supply agreements.
Internationally, many LNG supply agreements are being re-negotiated, while others are heading towards arbitration and/or termination.
While the long-term implications of COVID-19 remain unclear, the short- and mid-term impacts have the potential to reshape international markets as well as the geopolitical aspects of LNG trade.
Malta’s LNG supply agreements should be considered in this vein, and a re-evaluation of the purchase volumes and pricing structures should be embarked upon with a view to establishing a commercial balance between the parties, as is already happening in much of Europe.