The oil and gas sector has experienced a whole new world in recent months. Not long ago, the benchmark price for crude oil in the United States went below zero for the first time in history, and prices in Europe and Asia did not fare much better. Prices appear to have recovered somewhat but may well be subjected to more volatility in times to come. The COVID-19 pandemic has shaken supply and pricing expectations. Furthermore, the current situation has also resulted in governments actively considering implementing efficient energy initiatives which may significantly affect the oil and gas sector earlier and more radically than expected.
Low hub prices understandably cause concern for buyers under long-term sale and purchase agreements as these contracts are usually indexed to crude oil prices. Buyers are under pressure and many have already invoked – or are considering invoking - force majeure provisions arising from their inability to take volumes due to the current situation.
Disputes are now arising in the energy sector. Price review mechanisms are being triggered. Furthermore, it is expected that sale and purchase contracts will be terminated, with disputes arising as to whether such terminations were valid, in particular where there is reliance on force majeure and frustration.
This alert considers options that may be available to parties ahead of any dispute, as well as the types of dispute which may arise, particularly in an arbitral context given that many of these sale and purchase contracts contain arbitration agreements.
Options Available to Parties Before A Dispute
Once problems arise, parties should first consider working together to find commercial solutions to those problems. Various alternative solutions may be available to the parties, such as rescheduling deliveries, adjusting take-or-pay obligations, amending the duration of the contract, as well as adjusting the price and/or price formula.
Amending the contract price or the price formula is likely to be a key factor for many affected parties. Commonly, price adjustment clauses provide for good faith discussions between the parties, followed by arbitration or alternatively, expert determination where the parties fail to reach agreement. If the contract price or the price formula cannot be adjusted by agreement between the parties, a party's ability to impose an adjustment to the contract price will depend heavily on the exact particular language of any price review clause.
Many parties will seek to agree on solutions to the problems raised by the current situation. This may involve, for example, forgiving take or pay obligations and crediting them for the future, or introducing additional volume or destination flexibility. This helps maintain the commercial relationship, which is so often vitally important.
Whilst the drop in oil prices arose in response to the pandemic caused by Covid-19, it does not necessarily follow that buyers will have a contractual right to adjust the price under their contract. Often clauses will stipulate extended periods during which price adjustment clauses cannot be triggered - some long term gas supply contracts may provide for price reviews every few years, where others stipulate a first possible review at, for example, the mid-point in supply.
Where a party does have the right to trigger the contractual price review mechanism, it must of course closely follow the exact terms of the clause, in particular with regards to the procedural requirements specified. Both buyers and sellers will need to be well aware of their rights and obligations at this time.
If there is a right to trigger the contractual price review mechanism, parties will inevitably consider whether the difference between the contract price and the market price justifies a price review. At this point, certain considerations will come into play such as whether the contract specifies that the difference be maintained for a minimum period of time, whether there is a contractually stipulated minimum level of difference or whether the price difference must be assessed by reference to other markets.
Determining whether or not to shut down operations or to reduce production levels is another significant consideration that many parties may be assessing currently. Such a decision is likely to require approval under a joint operating agreement. In that connection, parties should be aware of default notification requirements, cure periods, changes to voting rights, as well as the options to purchase or forfeiture which may result in acquiring the defaulting party’s participation.
What Claims Might Be Available If Parties Cannot Reach Agreement?
Force Majeure may be available when facing non-performance of a contract. Much has been said and written about force majeure in response to the Covid-19 pandemic. In reality, force majeure is not as straightforward as may be expected under English law.
Most LNG SPAs will include a force majeure provision. It is too soon to know whether force majeure can be successfully invoked in light of the COVID-19 pandemic. A pandemic will not necessarily be covered by the force majeure provision. Force majeure is far from being a quick answer to the problem. The mere occurrence of a force majeure event will not automatically excuse performance, and a force majeure clause will invariably require a party to provide evidence in support of its claim of force majeure. Under English law, the party seeking to rely on force majeure will need to establish a causal link between the force majeure event and the failure to perform. In some circumstances, that party will need to prove that the force majeure event was the only cause of its failure to perform, with the result that if performance would have been prevented in any event, there will be no force majeure relief.
Frustration may be available to discharge the contract. Frustration discharges a contract when an unforeseeable event occurs rendering it physically or commercially impossible to fulfil the contract. Similarly, frustration may be argued when the unforeseeable event transforms the obligation to perform into a radically different obligation from that undertaken when the contract was concluded. It is worth remembering that English law applies a high bar. Furthermore, this is also not necessarily a commercially attractive option. Sometimes, a bad contract is better than no contract at all.
Breach of contract for failure to pay the buyer for taking the oil. As set out above, a seller faced with negative pricing may fail to perform its obligations under the contract by failing to pay the buyer to take the oil, resulting in a breach of contract.
It is important to consider whether the express terms of the contract stipulate what happens in this scenario, or whether the contract might set a ‘zero’ floor price which would effectively rule out negative prices. Alternatively, the contract might expressly allow for negative prices.
Many oil sale and purchase contracts will not expressly address negative pricing or even a zero floor for pricing, and such a position will require interpreting what is expressly set out in the contract in order to determine whether a negative price was ever contemplated by the parties, or whether such a term should be implied into the contract. In doing so, the express wording of the contract, in particular contractual payment mechanisms, will be pivotal. Where a contract is completely silent, a tribunal is most likely to adopt a common sense approach, mindful of the commercial context.
Whilst the situation may have evened out a little in more recent weeks, stability is by no means guaranteed and parties should be prepared for more volatility to come.