Introduction – the evolution of LNG trading contracts
The LNG trading market is evolving rapidly. Over the last decade, it has been one of the fastest growing commodities markets. This process has been accelerated by the increased demand for LNG in Europe and Asia and in the wake of Russia’s invasion of Ukraine.
The LNG trading market is relatively new. Intermediaries, such as trading houses and other ‘portfolio players’ (or ‘aggregators’) only began filling the gap between producers and end-users during the course of the last two decades. Prior to that, most LNG production was committed to long-term supply agreements, often with terms spanning 20 to 25 years or more.1 The rapid growth of LNG trading has created changes in how LNG is bought and sold, with more volumes than ever being traded through spot sales or short-term contracts. Recent data suggests that, during each of the past two years, around 30 per cent of LNG cargoes were traded on a spot basis.2 With a number of long-term contracts approaching their end in the near term, the opportunity for further growth in ‘spot’ or ‘shorter term’ deals is significant.
Some of the world’s largest market participants have made strides towards the standardisation of LNG trading documentation, in a bid to promote a transition to a trading model more closely resembling other commodities markets such as oil and products trading.3 The aim has been to standardise and streamline transactions to reflect and promote greater market liquidity. However, standardisation has been slow. This can in part be attributed to the historical dominance of producers (and, to an extent, end-users) who have wielded considerable negotiating power over their counterparties and/or are reluctant to move away from their own preferred trading terms. Some commentators see real change in this dynamic on the horizon.4
Contractual documentation used for LNG trading meanwhile remains unique. It is subject to complexities that do not exist in other trades. LNG has yet to become aligned with other globally traded products such as oil, refined products, coal, metals or grains in terms of standardisation. It might be said that this is an inevitable result of the complexity of the production processes or the terms on which LNG has to be originated from producers. But the fact remains that the unique features of LNG trading agreements create impediments to the expansion of the LNG trading market, especially for new entrants. Arguably, they undermine liquidity and create inefficiency. Many traders believe that current contractual arrangements lack sufficient optionality and flexibility.
The unique features of LNG trading agreements
What are the unique features of LNG trading agreements? LNG trading agreements are different from standard agreements underlying the trading of other products. Most LNG trades currently use master sale and purchase agreements (MSPAs). These are long, and sometimes complex, agreements negotiated bilaterally between parties seeking prospectively to engage with each other for the sale and/or purchase of LNG cargoes. They form the starting point for trading relations between two parties, but are subject to the use of additional, negotiated, and signed confirmations which adopt and apply the terms of the underlying MSPA. New entrants to the market cannot buy or sell without negotiating and concluding MSPAs with parties that will trade with them.
Is there scope for simplification and if so, how?
The short answer is “surely yes”, and there are plenty of examples of standard documents that have served other commodity markets well and which may be instructive. This paper does not attempt to identify all the solutions. But it seeks to provide examples of how LNG trading agreements deviate from general principles of law and/or standard forms used for trading other products.
Damages for breach or default
A noteworthy feature of LNG agreements is how they legislate for the calculation of damages in situations of breach by a party. They impose limits both in respect of the types of loss that can be claimed for breach and monetary caps on liability.
LNG MSPAs typically only allow the recovery of losses which are ‘actual’, documented, direct, and reasonably incurred. A claim for damages for a defective LNG cargo is often conditional on taking certain specific steps to avoid or mitigate loss. A buyer may therefore be obliged to use ‘reasonable endeavours’ to remediate a defective cargo and/or to make it marketable in circumstances where the law (and the Sale of Goods Act 1979) may otherwise confer not just a claim for damages but also a right to reject such a defective cargo. A buyer may even be required to accept a complete rescheduling of its LNG cargo without any recourse for the consequences relating to its hedging strategy or its onward sale commitments.
In the case of a failure to deliver or to take delivery, an innocent party is often precluded from bringing any claim for its losses unless it complies strictly with certain procedural requirements. An innocent party may have no right to damages unless it concludes an actual contract for the re-sale of the cargo (in the case of a seller), or the purchase of a replacement cargo (in the case of a buyer). An innocent party may be subject to obligations to produce evidence relating to an actual ‘substitute’ transaction or its failed, but reasonable, efforts to secure one.
This approach is not only more demanding than is common in other standard forms, but also deviates from the general position under English law which allows damages to be paid simply based on the difference between the market price and the contract price of the cargo as at the time of a default, subject only to the general, and far more forgiving, duty to take reasonable steps to mitigate losses. It presents a particular challenge for traders or aggregators who possess large portfolios of LNG volumes, since it can arguably preclude the re-allocation of an existing cargo from a portfolio to fill a gap arising as a result of the other party’s breach without that trader losing its right to seek compensation from the party in breach.
Most MSPAs include monetary caps on liability. Where a buyer accepts a cargo which does not meet the agreed quality specifications, the damages it is entitled to recover are typically capped, usually somewhere between 15 and 50 per cent of the value of a (notional) compliant cargo at the contract price. Damages in the case of failure to deliver, or failure to take delivery, are also often capped at a percentage of the price agreed for the cargo even though the true loss to an innocent party may be far greater. The potential for ‘gaming’ arises where the difference between the contract price and the market price exceeds the applicable liability cap. Why bother to deliver a cargo of LNG at a contract price which is lower than the market price when your liability to pay damages is in any event capped at an amount which is less than the price (and the profits) that can be earned through an opportunistic, alternative sale at a higher prevailing market price? The risk of a deliberate breach will be lower where the counterparties have a long and valuable relationship, but the risk certainly still exists and is significant at times of high volatility.
Force majeure
Typical LNG MSPAs include terms relating to force majeure which are more complex than those usually found in standard trading agreements relating to other commodities. Force majeure events are defined not just as unusual events outside a party’s control but often as events that would have been outside its control had it been acting as a “reasonable and prudent operator”. This type of additional condition brings into play a further layer of complexity for a party facing what the law would ordinarily consider to be a force majeure event. It requires the application of a notional additional standard of expertise that may be unknown even to the most experienced market participant, or which is simply hard to apply or predict – in practice and in real time – during episodes where parties must act with urgency.
The effect of this is to place a greater burden on a party wishing to rely on force majeure to excuse the non-performance of its obligations, exposing it to a far broader, retrospective enquiry into their conduct. This in turn must be judged by reference to industry practices as opposed simply to facts. Challenges to the reliance on force majeure are therefore more likely in the context of LNG agreements, and the potential for disputes is greater.
Processes for execution
It is common for LNG trades to require an early (binding) nomination of an exact loading port and terminal, and the identity of a performing LNG vessel. Such details, once declared, become hardwired into a contract – somewhat unusually even for CIF or DES deliveries of LNG. Accordingly, a seller cannot later deliver a cargo loaded at a different place or onto a different vessel unless the buyer agrees. Optionality and flexibility are therefore compromised. Conversely, if the seller’s ability to load at a nominated terminal, or onto a nominated vessel, is compromised, that may enable a seller to avoid liability for non-performance by virtue of force majeure. Again, this represents a material deviation from how the law and most other standard form contracts work.
Arbitration
The majority of MSPAs include arbitration agreements which in turn exclude statutory rights to appeal with respect to questions of law. There are strong arguments for and against this approach which are not addressed in detail here. However, one of the most significant results and disadvantages of this approach is that it has led to a dearth of judicial decisions on recurring questions of law arising out of LNG transactions.
Such decisions would serve as authority and precedent as to the interpretation of contracts. Relative to the volumes of LNG traded globally and compared to other traded products, there are very few legal authorities offering judicial guidance or binding precedent regarding the interpretation of terms. The consequence is that the industry faces uncertainty and risk because common terms may be interpreted and applied differently by different arbitral tribunals. In short, there is less clarity with respect to the interpretation of LNG trading contract terms which, in turn, creates uncertainty as to how such contracts must be performed. This may be viewed as advantageous for some market participants, but objectively the resulting uncertainty is probably unhelpful and may go as far as to make contractual execution difficult.
Performance standards
LNG MSPAs frequently include requirements rarely found in other standard form contracts, such as the performance of obligations by reference to standards of ‘good faith’. While the concept of good faith is widely adopted under many systems of law, most common law jurisdictions have not yet fully embraced its application in the context of commercial agreements. Meanwhile, few other standard form commodity trading agreements adopt ‘good faith’ as a standard required for the execution of the sale and purchases of commodities.
The use of the concept of ‘good faith’ arguably facilitates a harmonious approach to contractual relationships. However, it also creates a standard which can be uncertain, or a ‘grey area’, in the context of dealings which require simplicity, clarity and above all certainty. The interpretation of contract terms normally conditioned by context – their meaning and effect in any given case needs to be construed objectively by reference to the exact words used in the contract, the context of the contract as a whole, and a matrix of relevant facts. However, ‘good faith’ is understood as requiring the party to act within the spirit of the contract (or ‘the agreed common purpose’) and consistently with the other party’s justified expectations in order to observe standards of fair dealing. This uncertainty is not necessarily advantageous with respect to the performance of commercial agreements and is more likely to cause disputes than a more certain set of ‘black and white’ terms.
Takeaways – a simpler standard form?
The LNG market is currently in flux because of its rapid pace of growth, shifts in demand and supply patterns and volatility in prices. However, the LNG contracts currently in use are still heavily influenced by the historical standards and very long-term contracts. There is no single standard MSPA form which is widely used across the industry. Indeed, MSPAs are bilaterally negotiated. They include terms that deviate from trading norms and even from principles of law. The exclusion of the right to appeal in arbitration agreements means that publicly available judicial authority on the meaning and effect of common terms is lacking. Unless the industry develops more standardised trading terms which match the growing market for trading LNG, market participants (and especially less experienced market entrants) will continue to face challenges of uncertainty and arguably inefficiency.
- LNG buyers seek to dismantle rigid long-term contract structures in flexibility push.
- Spot LNG trade fell in 2022.
- BP publishes LNG contract templates to push industry standardization.
- LNG buyers seek to dismantle rigid long-term contract structures in flexibility push.
In-depth 2023-219
