Liquified natural gas, or “LNG”, is a hot topic that has gained prominence as a source of energy in the last decade. LNG has become a hot-button issue particularly following the spike in LNG prices in the wake of the Covid-19 pandemic, as well as Russia’s invasion of Ukraine and the pressures on oil and gas prices generated by the conflict. Since around April 2021, spot prices have increased almost tenfold, though prices have since trended downward, with certain commentators describing the market as bullish. Long-term LNG prices have also risen, albeit much more moderately. This presents a picture where spot and long-term prices for LNG, previously in more or less close correlation, are now considerably different.
Unsurprisingly, LNG suppliers locked into long-term supply contracts may seek to leverage the difference in spot and long-term LNG prices. They can do so in two principal ways: in the first instance, they can seek a price review. The underlying sale and purchase agreement (SPA) may itself contain a contractual mechanism for a price review (as is common in Asia LNG SPAs), or the supplier might otherwise seek to negotiate an amendment to the pricing mechanics in the SPA.
Second, it may be commercially attractive for an LNG supplier to default on its delivery obligations so that it might take advantage of high spot prices. While largely dependent on the terms of the contract and specifically the remedies for failure to supply, it may make commercial sense for a supplier to assume the consequences of a breach of contract, and any compensation payable as a result, because it may be more lucrative to sell to a third-party buyer at the higher spot prices rather than at the contractually agreed price.
There are a number of factors to consider prior to the supplier’s taking this option. The first concerns the contractual arrangements in the SPA, in particular any provisions on compensation for failure to deliver. Whether selling at spot prices is actually more lucrative will depend on the extent of the seller’s liability for a failure to supply, and will depend on a combination of the detailed SPA provisions and the governing law. For example, the governing laws of some jurisdictions (e.g. New York) allow punitive clauses for breaches of contract, whereas others (e.g. England and Wales) do not. Most North Asian long-term supply agreements have traditionally used New York law, although English law agreements are becoming more common. English law is also the law of choice for long-term supply agreements in other Asian countries. Where such contractual penalties are not permissible as a matter of law, liquidated damages will often be provided for in the SPA. Some LNG agreements provide that where there is a default in supply, the seller must pay the spot price. Such liquidated damages would allow the buyer to purchase LNG on a short-term basis in the short market. In such case, the seller’s profit would effectively be nought. However, in practice, buyers of LNG in Asia have often been unable to hold suppliers who defaulted on their obligations accountable beyond limited monetary compensation, often linked to oil prices, according to an S&P Global Commodity Insights article. There is considerable variability in contractual protections, with some SPAs even limiting the supplier’s liability in cases of non-performance.
We have reviewed shortfall or non-delivery provisions in four sampled SPAs, an exercise that yielded a varied picture. SPAs may set out damages formulae to calculate any compensation payable for a supplier’s shortfall. One such SPA links compensation payments to the simple average of NYMEX Henry Hub Prices (a core measure of LNG prices). Another SPA provides as “the Buyer’s sole and exclusive remedy” a right to compensation for shortfall deliveries (or non-delivery) in an amount equal to half the Contract Price. Yet another SPA provides that, by way of liquidated damages, the buyer may purchase any shortfall quantity of LNG in a given year at 90% of the then-applicable price in the following year. Where, however, the buyer has had to acquire replacement LNG to fulfil its own delivery obligations, damages are equal to the actual cost incurred in acquiring the replacement LNG, subject to actual proceeds received by the buyer being deducted. The fourth SPA provides for compensation of the actual, verified, incremental costs and expenses reasonably incurred by the buyer in taking delivery of replacement LNG, capped at 25% of the contract price relating to the non-delivered cargo.
Another factor to take into account when determining the commercial wisdom of defaulting on delivery obligations concerns the prospect of governmental regulation. Given these developments in the LNG market and the increasing importance of LNG as a source of energy, governments may seek to impose restrictions on defaulting on the supply of LNG, and/or impose significant penalties for non-performance. Suppliers would be well-advised to check the regulatory and legal framework in the destination jurisdiction before defaulting on contractual delivery obligations.
A further factor concerns the strength of the relationship between the supplier and the buyer, a point of significant importance in long-term commercial ventures. Defaulting on a long-term supply contract may yield significant short-term benefits for the supplier, but may be harmful in the long run and may damage the relationship between the supplier and buyer. Lastly, reputationally, a supplier may not want to be known in the market for purposely defaulting on its contractual obligations to take advantage of the higher spot prices. While this strategy has some risk, and relies effectively on a bet that the spot market will continue to be bullish over an extended period of time, our expectation is that the current disparity between spot prices and LNG long term prices will lead to parties renegotiating pricing terms (to the extent the existing price review mechanics would not work to remedy such disparity and provide parties with a satisfactory commercial outcome), rather than purposely defaulting.
In practice, price revision and default (or threats of default) are used in tandem. Care needs to be taken not to cross the line between commercial negotiations and economic duress, with the consequence that a revised price might be set aside by a court or tribunal. Perhaps unsurprisingly, price revision clauses tend to be the most litigated provisions in energy sale and purchase contracts.
Where the agreement makes specific provision for a price revision mechanism, those procedures should be followed in the first instance. Regular reviews every three to five years are standard. Interestingly, while it is normally buyers who seek a price revision (in the downward direction), given the LNG spot price hike, it is now suppliers who would be best place to seek such a revision (in the upward direction). That said, there are reportedly few instances of seller-driven price reviews.
Price revision may also be effected through arbitration proceedings. Notably Asian LNG contracts often contain what are known as ‘baseball arbitration’ clauses. ‘Day-time baseball’ means that all parties and the tribunal know the parties’ respective positions on price, whereas ‘night-time baseball’ means that the tribunal does not see the parties’ positions, with the party closest to the tribunal’s decision winning the day.