The COVID-19 pandemic and supply implications of the continuing lockdown are hitting the LNG sector hard. LNG prices have collapsed, with demand destruction, oversupply and a lack of storage creating the perfect storm for the industry. In this article, Partner Devika Khanna will focus on issues which commonly arise and should be considered early by market participants at this critical time.
Brent crude oil prices have plummeted and this week, the benchmark price for crude oil in the United States went below zero for the first time in history. Hub prices in Europe and Asia have hit all-time lows and the prospect of a quick recovery seems unlikely. As reduced economic activity has coincided with plummeting oil prices, the pre-existing imbalance between supply and demand has been exacerbated, leading to "lower for longer" price environment.
While low hub prices present an opportunity to those buyers who purchase LNG on a spot basis and/or have spare storage capacity, they are raising concerns for buyers under long-term contracts which are predominantly indexed to crude oil prices. Buyers are under pressure and many have already invoked force majeure provisions based on their inability to take volumes due to the current lockdown. In the same vein, or in circumstances where a contract (unusually) does not contain a force majeure provision (or a provision which is inadequate to cover the current pandemic), parties may also wish to consider the concepts of frustration and economic hardship, as well as their potential right to seek a price review with suppliers. These various options are in many respects complementary and can potentially be co-ordinated and used in succession depending on how the crisis pans out and importantly, how long its effects endure.
As ever, parties in any long term arrangement would be well-advised to seek to work together when faced with an unexpected crisis. Negotiated solutions might take many forms at the current time, depending on the commercial imperatives of the parties, for instance, rescheduling deliveries; adjusting take-or-pay obligations; amending the contract duration; introducing additional volume or destination flexibility; and of course adjusting the price and/or price formula.
Such negotiated outcomes offer the best chance to the parties of achieving a "win-win" solution, as far as is possible in the current situation. Markets are cyclical, demand and prices will of course rebound, and what goes around comes around. The question is whether long term partners can agree to share the pain, in the context of current uncertainty as to how long the aftershocks of this crisis will endure.
Force majeure remains the most readily-available and utilised remedy in the crisis thus far having already been invoked by many buyers around the world. LNG SPAs will usually include a force majeure provision, which may justify non-performance of contractual obligations if an event beyond the control of the parties occurs that hinders or prevents fulfilment of the contract. Depending on the wording of the clause, it may also entitle a party to terminate if the event in question endures for a specific period of time.
Whether force majeure can be successfully invoked in light of COVID-19 will depend on the terms of the clause and the specific circumstances said to result from the event in question. LNG SPAs ordinarily include a non-exhaustive list of events that may qualify as force majeure. It is important to note that the mere occurrence of a force majeure event will not automatically excuse performance. The clause may require that notice be given and a party provide evidence in support of its claim of force majeure. Typically parties will also be required to mitigate the effect of the force majeure event on the performance of their obligations, hence the reasonableness of steps taken during recent weeks may be called into question.
Parties might also be expected to seek to rely on arguments of frustration or economic hardship, both of which may apply depending on the governing law of the contract.
Frustration in English law is a common law concept that automatically discharges a contract when an unforeseeable event occurs after its formation which renders it physically or commercially impossible to fulfil the contract or transforms the obligation to perform into a radically different obligation from that undertaken when the contract was concluded. The bar of establishing that the contract has been frustrated is high since the English courts do not wish to allow parties to escape from what has proved to be a bad bargain.
Economic hardship may be claimed by virtue of either an express contractual hardship provision or an implied right depending on the governing law. A successful claim of economic hardship may allow a party to renegotiate (or even terminate) a contract in circumstances where unpredictable, external factors have impacted the equilibrium of the contract thereby rendering performance extremely onerous or potentially impossible.
Another option may be to seek to renegotiate the contract price for the LNG supplied. If this cannot be done by mutual agreement, a party's ability to force an adjustment to the contract price will depend on the particular language of any price review clause included in the contract.
Such clauses typically provide for good faith discussions between the parties, followed by arbitration (or less frequently expert determination) in the event that the parties cannot reach agreement, or in some instances may entail or permit the contract to be brought to an end if mutual agreement is not reached. Understanding the process and the end game is critical to devising the appropriate strategy in a particular case.
Whilst the pandemic may have dealt a blow to prices now, it does not follow that buyers will necessarily have a contractual right immediately to re-open the price under their long term contract(s). While some long term gas supply contracts typically provide for price reviews at three-year intervals, others often stipulate a first possible review at the mid-point in supply (e.g. at the 5-year mark), and thereafter every 5 years or so, depending on the duration of the contract and whether it is extended. In other words, it is typical for there to be extended periods during which such clauses cannot be triggered, and it will often be very much a matter of chance whether the current crisis coincides with such a right. The inclusion of additional "wild card" triggers, "for any reason, at any time" is rare in long-term contracts. As a result, buyers may find themselves locked in to an unfavourable price and will have to look to other routes where available (e.g. hardship). Given the prevalence of temporal restrictions around price reviews in many long-term contracts, it is not expected that there will be new tidal wave of price review disputes, at least not immediately.
Where a party does have a right to trigger the contractual price review mechanism, it must of course closely follow the letter of the clause in terms of the procedural requirements specified. Both buyers and sellers will need to be well aware of their rights and obligations at this time.
Assuming there is a right to trigger, the next set of questions will concern how to apply the review clause to achieve the aim of the process, i.e. to restore the contractual bargain of the parties by setting an appropriate revised contract price going forward. A key question will be whether the divergence between the contract price and market/hub price justifies a price review. Some review clauses require a change to have some duration; a temporary price shock might not meet the mark (albeit it is currently uncertain how long the present situation and its effects will continue). Does the review clause require any minimum level of divergence, or any comparative exercise to assess the situation by reference to any other market(s) or reference(s)? Does it require any analysis of the buyer's margin and/or its ability to economically market the gas? The latter could bring into question the reasonableness of actions taken by buyers in light of the current pandemic, including making reasonable efforts to mitigate/resell. Expert economic input is always critical in such cases and should be sought at an early stage in order to inform the strategy and price adjustment requested.
Finally, whatever immediate steps may be taken by parties in terms of crisis-management, they should keep under review the potential longer term impact of the current crisis on the equilibrium of their long-term contract(s) which may give rise to further rights and remedies down the line.