The global COVID-19 pandemic and the recent oil price shocks are compounding the issues arising from an already oversupplied LNG market, providing for additional challenges to LNG traders globally.
LNG traders who have entered into long-term LNG supply and purchase agreements (LNG SPAs) may be finding the current market particularly challenging. As a result of the COVID-19 pandemic in particular, there is both much weaker demand from China and economic contraction in Europe impacting the LNG spot market and end-users alike.
Previously, LNG storage has been favoured as a short-term option of last resort, with Spain being the destination of choice given the large volume of storage capacity available there. Currently, however, storage levels across the EU are already at record highs – 61% as of mid-April 2020 across the EU as a whole and 72% in Spain alone (FN1).
In light of the unique and challenging market conditions, it is important for LNG traders to understand their SPA provisions and what legal rights are at their disposal to help mitigate the current situation. In this client alert we will identify the most common clauses typically found in SPAs to help mitigate challenging market conditions, we will also provide practical tips on what to do in relation to each area identified.
Key clauses in long term LNG supply and purchase agreements
Volume and cargo flexibility
SPAs usually provide a mechanism for the parties to amend the annual delivery quantity (ADQ) for any particular year. It’s not usually possible to exercise such a right immediately, instead the clause will include a long advance notice period. Reducing the ADQ will in theory give the buyer the opportunity to reduce its exposure to the unfavourable market conditions, however it should be noted that, an LNG SPA would typically require the buyer to make-up the volume in a future ADQ via the operation of a ‘true up’ mechanism; where a depressed market continues for a number of years, this merely defers the issue rather than cures it.
Depending on the drafting of the clause, a buyer’s right to request an amendment to the ADQ may be limited to certain defined situations, or a buyer may only be able to make such a request a certain number of times during a specified period of time. If a buyer doesn’t meet the requirements or has already used up its quota of available requests, then an ADQ revision may not be available.
Working as an alternative to an ADQ reduction is the right to reschedule cargos which are already firm under an ADQ. It may be possible to reschedule cargos during each year of the term (or even defer cargos to later years). Such rights may be expressly included in the SPA or may rest on the commercial willingness of the other party to agree to amend the schedule.
| Practical Tips: Before requesting to reschedule a cargo or reduce the ADQ, check the SPA for an express right to do so. If a right does exist then check on its parameters and mechanics, to determine which party holds the relevant decision rights and to what legal standard must each party act during any negotiations (i.e. requirement to act reasonably or use its best endeavours or act in good faith). |
Rights to divert cargos
Usually an LNG SPA will specify one (or a small number of) unloading port(s) where delivery of LNG can be made. Provisions are sometimes included to give the parties the right to request for a diversion of an LNG cargo to an alternative port, or to add an alternative port to the defined list of acceptable ports for delivery. In the current market these rights could be helpful, particularly to a buyer, who may wish to divert a cargo to a more profitable destination or to an LNG facility in which it can obtain storage capacity. It is possible, but rare, for a seller to be able to nominate an alternative LNG facility from where the LNG will be delivered.
The quid-pro-quo for a seller agreeing to any such diversion is usually a profit share of any additional gains emanating from such diversion. This is due to different pricing indices being used for different geographical areas of the world (FN2). The LNG SPA will outline the applicable legal mechanics of this. As well as the profit share, additional transportation costs may outweigh the benefit of any such diversion and should be kept in mind by the buyer.
| Practical Tips: Check if diversion rights are included in the SPA. If a profit share element is included, ensure that the calculation is clear as to how the profit share operates and who bears what costs for delivery at an alternative port. |
SPA reopener provisions
The SPA may contain a price review or hardship clause which allows for the renegotiation of certain provisions in the SPA.
A price review clause will typically only be triggered after a specified number of years at the behest of one of the parties to the LNG SPA; likely the buyer in a falling market and the seller in a rising one. If timing is on your side, it is possible that 2020 may be a price review year and if triggerable could aid in a recalibration of the LNG price to the current market conditions. One issue to note however is that although price review clauses are fairly commonplace, they are notoriously vague as to what happens in the event the parties cannot agree on the new price and where deadlock ensues. This introduces uncertainty and possibly long delays, which by the time of reconciliation by arbitration, court or expert, the market may have shifted again.
A hardship clause on the other hand is often described as a derivative of a force majeure clause. Under such provisions, the parties are able to adjust the commercial terms (e.g. the LNG price) if there is a fundamental change in the underlying market and economic circumstances and the impact on one of the parties is catastrophic. Again, however, it is unlikely that a mutually agreeable solution would be easily found if a party triggered a hardship provision and an ensuing dispute in arbitration could take years to complete.
In some LNG SPAs, such a reopener based on a change of economic conditions is expressly prohibited, usually in the force majeure clause. A careful review of your LNG SPAs is therefore required.
| Practical Tips: If a price review or hardship clause exists, the first thing to ascertain is whether it is able to be triggered in the current circumstances. If it can be, a decision must be made as to whether it should be. Absent commercial good will, price review issues often end up in arbitration (and this is increasingly so in Asia focussed LNG SPAs) and so thinking ahead as to the consequences for a failure to agree should be kept in mind. A costly arbitration or battle in court may be sub-optimal than the status quo. |
Performance Assurance
Performance assurance or credit support clauses in SPAs have a number of triggers depending on the complexity of the relevant clause. The right to request performance assurance usually operate in favour of the seller and forms part of its contractual toolbox of risk mitigants. One relevant trigger in the current market situation is a ‘soft’ material adverse change (MAC) trigger. Depending on the drafting, this trigger will usually be met if in the reasonable opinion of the other party acting in good faith, a party’s ability to perform is materially impaired or that party is unable to adequately perform its obligations.
Other hard triggers may also be included such as a decline in the tangible net worth of a party to the LNG SPA or of a credit support provider. In the current challenging market, it may be easier for the requirements of these hard triggers to be met.
The affected party must usually then procure additional credit support to cover its obligations.
| Practical Tips: During uncertain times, it is essential to understand when a counterparty may utilise a performance assurance clause and require additional credit support. Hard triggers should be continually monitored by sellers and buyers. If the SPA contains a soft MAC trigger then its parameters must be understood. |
Early Termination Rights
SPAs may contain no-fault early termination rights which a party could utilise to end the commercial arrangement early. These rights are typically more likely to be available after the expiry of an initial term. As these provisions usually require significant period of notice before being exercised (sometimes a number of years in advance) then this nuclear option is unlikely to be of interest to parties looking to mitigate the impact of the current market conditions.
| Practical Tips: As a final option, a party may have the benefit of a no-fault termination right. Though this option may have broader reputational and commercial implications, especially if a party will continue to operate in the LNG market. |
What should LNG market participants be doing?
In a challenging market, it’s important to avoid surprises in your SPAs. Taking a proactive approach and reviewing SPAs in advance for key clauses and triggers is essential in order to mitigate legal risk and to formulate an action plan for the months ahead.
Sellers and buyers have competing interests in a challenging market. Sellers need buyers to ensure that their new facilities can obtain relevant financing and (of course) to maintain profit margins. Buyers struggling to on-sell LNG at a profit are ultimately at risk of default (or even insolvency in dire market conditions). It’s in the interests of both parties to act commercially in good faith and to cooperate with each other for their longer-term mutual benefit.
LNG market participants should be doing the following:
- LNG Buyers: should review the key clauses identified above with an aim to create and utilise as much short-term flexibility in their off-take arrangements as possible. Pushing out delivery schedules, diverting cargos to other ports (perhaps to take advantage of short-term LNG storage opportunities), considering available triggers for a price review and utilising any flex in its acceptance obligations will all help. At the same time, Buyers should take advantage of the favourable LNG prices in new contractual arrangements; doing so now may allow buyers to lock-in a comparatively low LNG price to offset higher prices in their existing portfolio.
- LNG Sellers: will often be able to call for performance assurance in the form of credit support if a buyer is facing financial or performance difficulty. Failure of a buyer to provide such performance assurance will likely trigger an event of default under the SPA. Sellers may retain discretion to refuse requests by a buyer for short-term flexibility and should take solace in the fact that there are usually long lead in times for flexibility to become operational. Notwithstanding the strict legal rights in the relevant SPA, it will usually be in the seller’s interest, however, to work with the buyer in the short term to ensure the long-term commercial relationship remains sound.
Footnotes:
FN1 – according to Gas Storage Europe’s Aggregated Gas Storage Inventory.
FN2 – LNG is priced predominantly on a Japan / Korea Marker (JKM) basis in the Asian spot market, whereas pricing based on the Dutch Title Transfer Facility (TTF) virtual gas trading point is more common in the European spot market.
The information contained in this Client Alert is intended to be a general guide only and not to be comprehensive, nor to provide legal advice. You should not rely on the information contained in this Client Alert as if it were legal or other professional advice.