Briefing 09 January 2017

The evolving nature of LNG sale and purchase agreements

Author:

Marc Rathbone

Partner
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Summary and implications

LNG market changes 

The LNG market has gone through many changes over the last decade, with the rise of the US as an exporter (shale revolution), record oil and gas prices, the growth of an Asia spot market and the proliferation of LNG facilities.

In Australia alone there are seven on-stream liquefaction facilities, with a further three under construction, five planned (of which two have been cancelled) and two under study (see here). Many of these projects have experienced cost blowouts, for example the Gorgon Project was around US$17bn over budget and more than six and a half years to first cargo from FID. The Gorgon project is a symbol of many LNG projects that were planned during a period of high oil prices.

With a marked downturn in the oil price towards the end of 2014, the LNG market has taken on a different persona.

Why is this an issue?

The majority of LNG sales in Asia are priced using crude oil or fuels indices (usually the Japan Crude Cocktail). Contrast this to US LNG contracts, which are based on Henry Hub.

Traditionally, long-term SPAs with solid pricing have underpinned project financing and ROI for many suppliers. So when oil was around $70–100bbl having a portfolio of long-term LNG supply contracts based on an oil-price indexation made sense and would allow developers/suppliers to secure funds to build these multi-billion dollar facilities.

Today?

Following from the oil-price plunge of 2014, the oil price still remains low and quite volatile. These trends have had and continue to have a widespread impact on the LNG sector. According to Bloomberg, less than 15% of long-term LNG contracts will expire in the next five years, with many not expiring until around 2040. This leaves many LNG contracts in an uncertain state and no longer aligned with the market. There could be significant economic impacts for those contracts that were "penned" recently and have yet to deliver the first cargo. For instance, from when Gorgon achieved FID the oil price has dropped by more than 57%.

With a developing Asian spot market and coupled with the downturn in the overall LNG price, the spot price of LNG has declined significantly – Japanese imports (average) was US$14.4/MMBtu in November 2014. However in November 2016 the average was US$7/MMBtu.

Help!

Buyers already in LNG contracts based on oil indices when oil prices were high must be seriously weighing the economic impact of such contracts on their bottom-line. A situation exacerbated by the traditional use of take or pay provisions in LNG contracts. Equally though this represents a risk to the LNG seller as well, in terms of the creditworthiness of the buyer.

How do I get a better price?

Many LNG SPAs do not contain any provisions for a downward review of price. This can be exacerbated in contracts governed by common law jurisdictions, where one of the underlying [tenets] of a bargain reached by commercial parties is that courts will seek to enforce the bargain made on its terms (obviously there are exceptions).

At one extreme, where the buyer is truly in economic hardship the only choice when all else fails is to "close shop" and "walk away" from its obligations, with the seller being left with little remedy and lenders to satisfy.

Those parties that had the foresight to include a price review or adjustment clause in their LNG contracts are still not necessarily out of the woods. Generally most price adjustment clauses are of a ratchet type and not designed for downward movement. Those that are are often unsuited to the purpose and not drafted with the LNG market in mind. Hardship clauses may feature in some contracts but these are often of little help, obliging the parties to meet and discuss (which should always be the first action), but not affording a firm solution, and often funnelling the parties to arbitration.

Before arbitration becomes the only solution it is advisable to have planned well in advance not only the commercial negotiation strategy but also a strategic path to arbitration including exit strategies. Whilst there are many advantages in seeking arbitration, when viewed in the context of an LNG SPA there are some unique issues faced by arbitral parties, including the lack of LNG market and LNG SPA experience by the arbitrator.

What now?

There are clearly 2 sets of players – those that are locked into contracts and those yet to execute an LNG contract.

New players

Many of the factors above that are influencing the market are also driving certain behaviours amongst new buyers – such as more spot buying and trading of cargoes (spot featuring in companies portfolios), a move to more short- to medium-term contracts and consideration of a price not linked to oil.

For those that are about to embark on negotiating an LNG SPA, it is critical to ensure that a more diversified approach is taken to the development of the terms of the SPA. This should include accounting for greater than normal shifts in the gas supply and demand balance, regulatory changes and effects on the SPA and the issue of price fluctuations causing commercial hardship (to name a few).

A move away from oil-based pricing is not necessarily new, consider Sabine Pass. On 25 October 2011 BG Group (BG Gulf Coast LNG, LLC) signed a 20-year contract to buy most of the production from Cheniere's Sabine Pass’s first train. The contract price was linked to Henry Hub.

Contracted players

For those that are locked into long-term LNG contracts many may be considering making moves to renegotiate the commercial terms of those LNG contracts, or where they are "State backed" initiating a G2G discussion.

Whether you are a new player or looking for help with existing LNG contracts, it is important that you seek early input. 

Nabarro has a world-class oil and gas team that has experience all along the LNG value chain. We have a very close-knit team that specialises in transactional as well as dispute resolution. This practice will soon be enhanced by a three-way merger with CMS Cameron McKenna and Olswang.