Guest blog by Paul Davis (Baker & McKenzie, Sydney/Tokyo) - "IMPORT OF US SHALE GAS INTO ASIA: THE EFFECT ON EXISTING LONG-TERM CONTRACTS FOR THE SALE OF LNG"
[A footnoted version of the following note is forthcoming on the Baker & McKenzie website. The firm supports ANJeL's 'Team Australia' law students in the INC negotiation and arbitration moot competition in Tokyo (held over 1-2 December this year), and Mr Davis is a guest lecturer in Sydney Law School's LLM courses in "Global Energy and Resources Law" and "Law and Investment in Asia". The law and practice of long-term contracts is not only of immediate practical significance for bilateral and regional trade and investment (including Australia-Japan FTA negotiations), but also more broadly for contract law reform projects now underway in both Australia and Japan.]
Current Top Concern to Asia's LNG Buyers and Sellers
The main issue exercising the minds of Asia's LNG sellers and buyers is what will happen to their current LNG sale and purchase agreements (SPAs), which are priced based upon the Japan Crude Cocktail (JCC), as cheaper (Henry Hub linked) shale gas imports start to flow into the region from North America.
Buyers will be under pressure to "close the gap." At the same time the sellers are concerned to maintain the prices based on which they made the decision to develop their LNG projects.
SPAs differ, depending upon the LNG SPA model preferred by the seller - in effect the operator of the project. However most SPAs contain two provisions of relevance to the current issue.
Price Review Clause
The existing Asian SPAs are usually for terms of between 10 and 20 years. While prices are invariably linked to the JCC, the contracts often reduce price volatility by building floors and caps (or "s-curves") into the pricing mechanism.
The contracts also usually (but not inevitably) contain a price review provision, which may consist of several elements.
Where the buyer is a foundation buyer, the review clause will often contain a "most favored customer clause" such as:
The price paid by the buyer shall not be materially higher than that paid by other buyers from the project.
Such a clause is often accompanied by a most favored supplier clause:
The price paid by the buyer shall not be materially less then the price paid by the buyer's other suppliers.
These clauses would not give relief to the buyer when cheaper North American shale case becomes available.
Of more relevance is the market parity clause, which seeks to ensure that the price will not be out of line with a particular market.
The price shall be based on the pricing of similar sales [ into Japan][into the North Asian market]
Sometimes the comparison is made against current imports into Asia/Japan, sometimes against new long-term contracts into Asia/Japan and sometimes both tests are applied.
The SPA usually provides that the review takes place at specified intervals (e.g. every five years) but in some cases it occurs when requested by one of the parties. Often the test includes a materiality threshold, e.g. requiring that the party seeking to reopen the price establish that it is materially worse off.
Questions which arise in practice include: whether the trigger to bring the clause into operation has been met , whether only the discount factor to JCC or the whole pricing mechanism is to be reviewed , and what happens if the parties do not agree.
The answer to the latter point depends upon the wording of the contract. Some contracts provide the matter will be decided by arbitration. Some make it clear that if no agreement is reached there will be no change. Often however the review clause is such a sensitive matter in negotiations that the parties, consciously or unconsciously, leave the question open. In this case the wording of the disputes clause becomes key. For example does it cover disputes only or also failure to agree?
Asian SPAs are almost always governed by either English or New York law. English courts in particular tend towards interpreting contracts literally and avoiding allowing the court to fill the gaps, and arbitral tribunals are supposed to apply the governing law. On the other hand, courts and tribunals also tend to take account of the fact that in entering the contract one party may have relied upon a particular set of circumstances that were known to both parties. It will be interesting to see how these factors play out in the Asian LNG SPA context.
Most long-term SPAs also contain some kind of hardship clause. Hardship clauses differ from review clauses in a number of respects:
Rather than being triggered at a specific point in time, as if often the case with price review clauses, hardship clauses can be triggered at any time if a specific test is met, such as:
Upon a substantial change in circumstances resulting in one party suffering substantial hardship.
The clause usually provides for a review of all provisions of the contract causing hardship, not just price.
Some contracts make it clear that the obligation is to discuss only; if no agreement is reached the matter is not subject to arbitration. Other contracts are ambiguous on the point, consciously or unconsciously.
What is likely to happen in the market?
While the parties to the Asian LNG SPAs will no doubt attempt to resolve the price gap problem through commercial negotiation, the issue is of such importance that the negotiations will inevitably take place against the backdrop of the parties' views of their legal rights.
It is hard to see how cheaper imports of LNG from North America would fall within the most favored customer clause. Such imports should, at least at first sight, trigger the market parity clause, but this depends upon the actual wording of the clause. If for example the clause requires a comparison with "similar sales" the seller may argue that only sales from e.g. Australia are "similar". Another issue will be timing - at what point will lower priced imports be sufficient to have in effect changed the market?
If the market parity clause does not apply, or the SPA does not have such a provision, the buyer will need to try and seek relief through the hardship clause. One way he may be able to do this is by showing that the regulator has reduced retail power or city gas prices because of the availability of such imports.
As for new contracts, there is a move away from pricing mechanisms based solely upon the JCC and the media reports that buyers are predicting the end of oil based pricing. Price review clauses are also likely to change, with the realization that they have not met the needs of the changing market.