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Turbulent times shine a light on imperfect contract structures

The pandemic provides an opportunity for a significant reset of contract structures

Extreme price movements and Covid-19-related issues have put considerable stress on contracts that work well under normal circumstances. It has also highlighted issues around indexation that were never really ideal. The question for the future is the extent to which lessons can be factored into the drafting of future legal agreements, according to the panellists at the PE Live 3 webinar.

A lot of the focus in contract development in recent years has been around enhancing optionality and flexibility. “We have seen a gradual shift towards a more flexible long-term LNG structure,” says Richard Nelson, partner at law firm King & Spalding’s energy practice. “It may be that post-Covid-19 we see a shift back towards focusing on more fundamental terms in the contracts. Force majeure and termination rights are absolutely critical but sometimes get overlooked in the heat of negotiations.”

Another area of renewed focus may be credit support—the extent to which parties are required to backstop their obligations to cover termination liabilities—for example to cover liquidated damages.

“The index of choice has been Henry Hub because of its depth of liquidity” Goncalves, Berkeley Research Group

“There is a case to be made for reviewing some of those provisions,” says Nelson. “But we have to keep in mind equally that the purpose of long-term contracts is to underpin very, very expensive and highly capital-intensive projects, to the tune or billions and billions of dollars, so there needs to be a stable and secure revenue stream to underpin that.

“Even if change were desirable, to look again at contract structures, that does not necessarily mean that the industry will be in a position to change some of the really fundamental terms.”

While Nelson is “bearish” about changes to the long-term contracts, he sees changes to short-term contracts as a “completely separate question”.

He says he has seen a greater change in spot contract arrangements, such as master sale-purchase agreements (MSPAs). “They started out as single cargo spot contracts but have morphed into a more general short-term contract covering multiple cargos and strip deals over two or even three years.

“We have seen contracts being adapted to align better with downstream gas supply terms. We have worked on some recently that are essentially LNG supply and downstream gas supply contracts all rolled into one. There is an argument that these changes will continue apace and I expect to see more evolution.”

LNG indexation

One less-than-ideal feature of gas contracts it that they are commonly based on the price of a different commodity, oil. The most desirable alternative to oil linkage must be considered in the context of US LNG contract prices substantially under-trading Asian markets in recent years, according to Christopher Goncalves, managing director, BRG energy & climate at consultants Berkeley Research Group.

“Henry Hub contracts can be as much as 20-30pc of the new volume in contracts in a given market area. They are a marginal, but substantial part of the market,” he says. “There is an analytic problem, how do you reset an oil-indexed contract that is based in part on benchmarks that are tied to a completely different price index? Often the best solution is a hybrid index, for example an 80/20 blend of oil and Henry Hub.”

In Asia, Goncalves sees increasing indexation to NBP or TTF on shorter term contracts: “There is some dynamism around indexation right now in the market for new contracts.”

When parties consider a review, renegotiation or a new contract, the choice of index will be based on a few common considerations. “Hedgeability, depth and liquidity, are very important,” he says. “That only leaves a few options—you probably cannot even consider anything for gas and LNG except Henry Hub, NBP and TTF. There really are no other options.”

Goncalves notes that while the Japan/Korea Marker (JKM) is “coming along” it not there yet; some observers expect it to take two years before there is sufficient liquidity, others as long as ten.

“The index of choice has been Henry Hub because of its depth of liquidity—it is the world’s most liquid traded gas index and, from a buyer perspective, has the benefit of the shale gas revolution and abundant US supply. And is extremely stable… so it is still the most likely choice.” 

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