|Issue Number: 107||April 2014|
The Risks of Long-term LNG Contracts.
Long-term contracts are widespread in the energy business. The initial project structure of a Liquefied Natural Gas (LNG) project usually reflects the length of the long-term contract, which is about 20-25 years. Long-term LNG contracts are, however, vulnerable to the rapidly changing landscape of global markets. Events such as the shale gas revolution in the US or the Fukushima nuclear disaster in Japan can precipitate dramatic swings in contract value and can bring either large losses or gains to contract parties under the original terms and conditions.
This article explores how fluctuations in the global markets have greatly influenced LNG prices and left unhappy contract parties. Although commercial issues can usually lead to changes in the original contract, some contracts do not always have a price reopener clause. Long-term LNG contracts can be risky business.
Gas Natural v. Atlantic LNG
In 1995, Gas Natural entered into a 20-year Sales and Purchase Agreement (SPA) with Atlantic LNG to buy 1.1 million tonnes of LNG per year. It was stipulated that LNG would be destined primarily for the receiving terminals in Spain, though there was an added clause so it was possible LNG cargoes to be diverted to the Everett terminal in Boston, USA. A provision was included in the contract which stated that regardless of the cargo destination, Gas Natural would only pay the Spanish pricing formula.
However, something unexpected happened that had huge implications for Spain's natural gas prices. In the early 2000s, there was a rapid liberalisation of the Spanish gas market, leading to a huge drop in gas prices. Responding to this, Gas Natural signed a six-year contract with GDF Suez, so Atlantic LNG would be sold to the American market, where gas prices were rising at the time.
Atlantic LNG was unhappy over this decision because the gas was ultimately being sold under the Henry Hub pricing system but it was not benefitting from the increased prices. Atlantic LNG triggered the price reopener clause in the contract, and demanded an estimated $1 billion increase through the life of the contract. Atlantic LNG claimed that since none of the cargoes were being delivered into Europe, the price formula should be raised to match the higher US gas prices.
Gas Natural counter-claimed that the price of gas sold to end-users required a reduction of around $2 billion through the life of the contract. After six months of discussion over the new pricing formula, negotiation broke down and Atlantic LNG initiated an arbitration case in October 2005.
The arbitration panel decided that it sought to maintain a reasonable profitability for Gas Natural under the changed market conditions. It agreed that US gas prices should be the basis for determining the value of the gas, and that Atlantic LNG should not share in this profit. This was a major loss for Atlantic LNG. The decision of the arbitration panel has been estimated to have cost Atlantic LNG between $500 million and $1 billion. The arbitration panel imposed its verdict with very little input from Gas Natural or Atlantic LNG's views, which surprised many commentators.
GAIL v. Petronet
GAIL, India's state-owned gas company, has recently sought to renegotiate an LNG deal made with Petronet over Australia's Gorgon project. The contract will last for twenty years (2015-2035) and 1.44 million tonnes of LNG will be delivered every year. The LNG price (as expressed in $/MMBtu) is equivalent to based on 14.5% of prevailing oil rates (as expressed in $/barrel).
At the currently mathematically convenient oil price of approximately $100/barrel, this equates to a base LNG price of $14.5/MMBtu. Including shipping costs, import duty and the costs involved in regasification, the gas will cost nearly $18/MMBtu. This stands in stark contrast to the Henry Hub gas price which is currently around $4.50/MMBtu, making the delivered price of Gorgon gas almost four times more expensive. It is far more costly compared with the LNG GAIL buys from Qatar, which works out at about $10-12/MMBtu.
Officials in India's Petroleum Ministry said that in July 2013 GAIL Director Prabhat Singh had written to Petronet's Managing Director seeking a reduction in the price of Gorgon LNG in light of changing global markets, and said:
'I would like to bring to your kind attention that the circumstances under which the price provisions (at higher slope linked to Japanese crude) were agreed in the said sale purchase agreement (for Gorgon) have changed significantly…'
Since signing the contract in August 2009, there have been significant changes in the gas markets. The regional gas prices in North America, Europe and Asia have seen a record divergence, driven by supply and demand factors such the European financial crisis, the US shale revolution and the Fukushima nuclear crisis. The graph below shows the large divergences between the different gas indexes.
Figure 1: Comparison of gas price indexes.
The Indian Rupee's depreciation against the Dollar will make buying the LNG even more costly. The graph below shows the far stronger position of the Rupee in relation to the US Dollar when the contract was signed in 2009, which was around 45-50 INR per 1 USD. However, the strength of the Rupee against the US Dollar has now declined and is around 60 INR per USD.
Figure 2: 5 year history of the INR against USD.
Petronet's unwillingness to renegotiate?
Petronet has since responded to GAIL's request and asked what justification there is for a possible renegotiation, as there was no price reopener clause in the contract. The only way forward for a potential renegotiation is for both GAIL and Petronet to agree to negotiate. In contract situations like this, a renegotiation can usually take place because of commercial concerns. However, some commentators have suggested that there are other possible actions for GAIL. GAIL could try to trigger renegotiation through subtle threats and it could hint at the inability to complete the contractual responsibilities. A more extreme option would be to default deliberately in order to initiate a renegotiation. This is not without precedent in the gas industry, and it has happened in the UK in the period 1995-98 when gas prices collapsed and many contracts became 'out-of-money'. However, this would be likely to represent a bad commercial decision making it harder for GAIL to purchase from other LNG sellers in future, as well as leading to the risk of litigation. A more likely solution would involve Petronet agreeing to renegotiate because it wants to retain a good relationship with GAIL.
These two examples of LNG contract disputes reveal how unexpected events can influence LNG markets and create commercial tension for one party to a contract. In the ongoing contract dispute in GAIL v Petronet, where there is no price reopener clause, it shows the importance of devising a satisfactory pricing formula that is resilient and flexible to fluctuations in the market, although this is always hard to achieve in practice. This example also indicates the importance of choosing a seller who has a proven record for negotiating 'in good faith'.
The case of Gas Natural v Atlantic LNG is more complex because it reveals that just as important as carefully negotiating the LNG price and price formulas in the Sale and Purchase Agreement is the nature of the price reopener clause. If a case comes before an arbitration panel, the price reopener clause must be defined carefully, so the arbitrators do not have a complete control over it. This would prevent arbitrators from imposing a pricing mechanism that neither party requested.
Researched and written by MJMEnergy Analyst, Nico Cottrell,