November 2012, Vol. 239 No. 11
Features
LNG Contracts Require Require Diligence, Caution
As natural gas prices in the United States approach their lowest point in a decade, several companies are in the early stages of developing liquefaction terminals to facilitate LNG exports.[1] Capacity at or output from these facilities is being snapped up by customers and buyers long before the facilities themselves are completed.
With so many companies competing for expected available liquefaction capacity and/or LNG output, potential customers must negotiate project agreements quickly and carefully. This article summarizes several project issues impacting LNG agreements and provides examples from two publicly filed purchase and sale agreements.
A person may obtain LNG through either a purchase and sale agreement or a tolling agreement.
Under a tolling agreement, the customer procures its own feed gas, delivers it to the liquefaction facility and pays the facility operator for the service of having it liquefied and the LNG delivered. The delivery of the LNG in this case is normally at the loading point of the customer’s vessel at the liquefaction terminal. Customers will normally pay a fixed charge for the right to receive the service, regardless of whether the service is used or not, plus a variable charge as a function of the actual service demanded.
Under a purchase and sale agreement, the seller procures feed gas, converts it to LNG and sells the LNG to its purchasers. The point of delivery may be at the liquefaction terminal (FOB sale) or at a designated import terminal (ex-ship sale). Many purchase agreements contain “take-or-pay” clauses giving a purchaser the choice to take and pay for the LNG it has contracted for or to decline the LNG and pay a fixed charge with the right to take the LNG at a later time.
Alternatively, a purchaser that does not take and pay for the contracted volumes is liable for the payment of cover damages to the seller. A take or pay structure benefits the purchaser by giving it the flexibility to take LNG or not based upon its needs without breaching its contract. It also benefits the seller by giving it assurances that it will be paid regardless of the purchaser’s decision.
Services And Obligations
Under purchase and sale agreements, the seller is obligated to deliver and the purchaser is obligated to take and pay for specified amounts of LNG. Under tolling agreements the operator is obligated to be available to render the liquefaction service at the request of the customer up to the contracted volumes. Tolling agreements will also require the operator to provide the service of treating the feed gas, and may provide for associated services such as the storage of feed gas or LNG.
In both the LNG Sale and Purchase Agreement (FOB) dated Jan. 30, 2012 between Sabine Pass Liquefaction, LLC and Korea Gas Corp. (the “Kogas Agreement”) and the Amended and Restated LNG Sale and Purchase Agreement (FOB) dated Jan. 25, 2012 between Sabine Pass Liquefaction, LLC and BG Gulf Coast LNG, LLC (the “BG Agreement”), Korea Gas Corp. (“Kogas”) and BG Gulf Coast LNG, LLC (“BG”) are required to take a specified quantity of LNG less (1) quantities unable to be taken for reasons attributable to Force Majeure affecting the purchaser; (2) quantities for which the purchaser exercised a contractual right to cancel delivery; and (3) quantities of LNG not meeting contractual specifications.
Conversely, the seller under these agreements is required to make available a specified quantity of LNG less (a) quantities not taken by the purchaser for reasons attributable to the purchaser and not otherwise excused, including quantities not taken due to Force Majeure; (b) quantities for which the purchaser exercised a contractual right to cancel delivery; and (c) quantities not made available by the seller due to Force Majeure.
Within scheduling and quantity considerations, it can be useful to build in some operational tolerance. In the Kogas Agreement and the BG Agreement, failure to take in amounts within 2% of the agreed-upon quantity of LNG is not considered a breach of the agreement.
Other clauses from the Kogas Agreement and the BG Agreement providing some limited flexibility include (1) allowing the purchaser to push a monthly quantity of LNG into a subsequent month; or (2) allowing the seller, with the purchaser’s consent, to push a monthly delivery of LNG into a subsequent month.
Conditions Precedent
Both purchase agreements and tolling agreements require the parties to make a long-term commitment to each other, in some cases as long as two decades. Market conditions are also forcing buyers and customers to enter into agreements long before the LNG facilities are operational.
Conditions precedent must be used to provide customers with some assurance that they won’t be tied to an economically fruitless contract for years. For example, conditions precedent in the Kogas Agreement and the BG Agreement include (1) receipt by the seller of all approvals required to construct and operate the liquefaction facilities (since granted); (2) the seller securing all necessary financing arrangements to construct the facilities (since done); and (3) the receipt by the seller of all governmental approvals required to export LNG from the United States to any country with whom the U.S. does not have a trade embargo (since granted).
Both the Kogas Agreement and the BG Agreement contained a date upon which the Agreements could have been terminated if such conditions precedent had not been satisfied.
Commercial Operations
After all conditions precedent for the effectiveness of the agreement have been met, customers usually also insist on a drop-dead date allowing a customer to terminate the agreement if commencement of commercial operations of the new facility is not achieved by a certain date. Under the Kogas Agreement, a liquefaction train is considered commercially operable when (1) it has been commissioned; (2) it is capable of delivering LNG in quantities sufficient and quality necessary to permit the seller to perform its obligations under the agreement; and (3) it is constructed in accordance with the agreement.
Damages
Purchase agreements without a take-or-pay provision typically provide for cover damages if the seller fails to supply LNG or the purchaser fails to take LNG pursuant to the terms of the agreement. Because purchase prices are typically indexed in some way to market prices, the parties are able to determine their damages to a certain extent in advance of a breach.
The Kogas Agreement provides for compensation from the seller to the purchaser for failure to deliver LNG as well as from the purchaser to the seller for failure to take LNG. If the purchaser fails to take LNG as obligated beyond the 2% operational tolerance, it must compensate the seller for the shortfall in an amount equal to (1) the contract sales price multiplied by the amount of the shortfall; minus (2) the proceeds of any mitigation sale by the seller; minus (3) any reasonable and verifiable savings resulting from the mitigation sale; plus (4) any reasonable and verifiable costs incurred as a result of the mitigation sale.
If the seller fails to deliver LNG as obligated beyond the 2% operational tolerance, it must compensate the purchaser for (a) the documented price incurred by the purchaser to purchase replacement LNG, or the market price of LNG at the time; minus (b) the contract sales price; plus (c) any actual, reasonable and verifiable costs incurred by the purchaser due to the seller’s failure to make LNG available; plus (d) any actual, reasonable and verifiable costs incurred by the purchaser due to idling the vessel scheduled to load LNG; minus (e) any actual, reasonable and verifiable cost savings realized by the purchaser due to the seller’s failure to make LNG available.
Tolling agreement operators are less willing to provide cover damages in favor of their customers because they are providing a service rather than selling a good. Because service fees are not usually indexed to the market price of LNG, the operators could find themselves otherwise facing commercial liabilities far exceeding anticipated commercial margins.
However, a tolling agreement customer may still have end use requirements requiring it to purchase LNG on the open market if the tolling operator fails to comply with its service requirements.
Termination Rights and Force Majeure
In long-term contracts such as LNG agreements, clear early termination rights can guard against changed circumstances impacting a party’s expected economic benefits. Examples of events triggering early termination rights in the Kogas Agreement and the BG Agreement include (1) the failure of the purchaser to take or the seller to make available more than 50% of scheduled cargos in any 12-month period; or (2) Force Majeure preventing a party from taking or making available 50% or more of specified quantities of LNG for a total of 24 out of 36 months.
Because events of Force Majeure can give rise to termination rights, a purchase agreement or tolling agreement should clearly specify what events do and do not constitute events of Force Majeure, how long an individual event (or several events in the aggregate) must continue before termination rights arise, and whether a partial impact such as an inability to take or supply a portion of contracted-for quantities due to Force Majeure gives rise to termination rights.
Purchasers may also wish to negotiate for downstream events of Force Majeure, such as events affecting the purchaser’s vessel or its regasification facilities. This may be more palatable to a seller if a purchaser intends to supply the LNG in a defined market with a limited number of end users, but less so if the purchaser is a trader with access to a wider range of potential customers.
The commercial viability of a liquefaction project frequently depends on authorization from the federal Department of Energy (DOE) to export LNG to a country with which the United States does not have a free trade agreement requiring national treatment for trade in natural gas. Changes in the circumstances underpinning the authorization could lead to the withdrawal of a granted authorization.
Additionally, the DOE could revoke an entire facility’s authorization if one of its customers or buyers violates the terms of the authorization. It should be made clear in both purchase and sale agreements and tolling agreements whether either (1) the withdrawal of an authorization due to government action or (2) the revocation of an authorization due to the actions of another customer or buyer in the same facility constitutes an event of Force Majeure excusing performance.
If such events are considered Force Majeure, further consideration must be given to whether they excuse the performance of the buyer/customer, the seller/operator, or both. Buyers and customers may not want to bear the risk of a third-party buyer or customer violating a facility’s authorization, but sellers and operators will want such a risk spread among all parties. Under the BG Agreement, the loss of an export authorization due to the actions of another buyer does not constitute an event of Force Majeure under an unrelated contract.
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[1] As of Sept. 21, 2012, there were five projects awaiting governmental approval to export LNG to countries with which the United States has entered into a free trade agreement requiring national treatment for trade in natural gas and 13 projects awaiting governmental approval to export LNG to countries without such free trade agreements. See “Applications Received by DOE/FE to Export Domestically Produced LNG from the Lower-48 States (as of Sept. 21, 2012),” available at index.html (last visited Oct. 9, 2012).
As of July 17, 2012, 11 projects had been proposed to the Federal Energy Regulatory Commission or identified to the FERC by project sponsors. See “North American LNG Import/Export Terminals, Proposed/Potential,” at http://www.ferc.gov/industries/gas/indus-act/lng.asp (last visited Oct. 9, 2012).
Authors
Robin Clarkson is an associate in the Houston office of Mayer Brown’s Corporate & Securities practice. Her practice focuses on mergers and acquisitions, energy transactions, capital markets and general corporate governance. She also represents oil and gas companies in matters including expansion projects and contractual issues.
Jose L. Valera is a partner in the Houston office of Mayer Brown. Focusing his practice on domestic and international energy transactions and project development, he has more than 25 years of legal experience representing oil, gas and electric energy companies throughout the United States, Central America, South America, Africa, Asia and the Caribbean.
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