Decarbonisation imperils long-term LNG contracts
Failing to incorporate greater flexibility into LNG purchase agreements could spell trouble as nations get tough on carbon emissions
LNG producers are failing to include sufficient protections against unforeseen events in their contracts with buyers—an oversight that could lead to expensive litigation should deals turn sour, a top industry lawyer told the 2020 Gastech Virtual Summit last week.
The annual contract volume of 20-year LNG sales-and-purchase agreements (SPAs) has slumped over the past decade, from a peak of around 25mn t to about 12mnt last year and less than 2mn t so far in 2020. But they remain an industry staple despite doubts over LNG’s long-term profitability.
“Shorter duration contracts are still very long term... [there are] requirements for flexibility at all levels and pretty much in all ways,” says Paul Griffin, senior adviser and counsel to the global oil and gas group at law firm White & Case. “The commercial effects of decarbonisation are now becoming part of these discussions.”
Societal moves to cut emissions—in both LNG exporting and importing countries—are deepening industry uncertainty, with state policy changes presenting material risk. Yet buyers and sellers continue to enter into 20-year contracts that do not explicitly address the potential impact of decarbonisation—whether commercial, regulatory, fiscal or legal, Griffin warns.
“The commercial effects of decarbonisation are now becoming part of… [LNG contract] discussions” Griffin, White & Case
“Whether you are looking at new projects or existing SPAs, the risk of reduced value and balance of risk shifting between parties is a very real one,” he says.
“The LNG SPA will tend to be a detailed arrangement and provide sophisticated allocation of risk between the parties, but if a risk is not foreseen—and very few LNG SPAs mention the word “pandemic” [for example]—then what is to happen?”
Recently signed contracts will expire around 2040, which is getting close to the period when governments and organisations are aiming to be net- or near-zero in terms of carbon emissions.
“Recovery costs will be at risk, even the effective rate of return,” says Griffin. “When you turn to your contract, are you looking for the text, which is going to give the answer, or the context of the arrangement made? If you do find the text to address these circumstances, which are typically unknown at the beginning, it will be largely be accidental.”
Impact on volumes
Long-term contracts are becoming smaller, with average volumes (now) less than 2mn t/yr, while some are for below 1mn t/yr, according to Douglas Wharton, vice president of origination and marketing for Asia at Cheniere Energy.
“Are long-term contracts in terminal decline? We believe the answer is no,” says Wharton, highlighting how such agreements provide a hedge against spot price volatility. Yet new buyers and new LNG markets are less able to bear “traditional” risks, he notes.
“The energy transition is creating longer-term uncertainties… carbon considerations add another dimension to long-term LNG contractual commitments,” says Wharton, adding short-term volumes now account for more than 30pc of trade.
3.4pc – LNG demand growth (CAGR) 2019-40
The increasing prominence of environmental considerations in state policymaking and deepening consumer hostility to fossil fuels make it harder to predict future LNG volumes, although Cheniere forecasts LNG demand will grow at a CAGR of 3.4pc from 2019 to 2040.
Nevertheless, SPAs could change their status from that of firm obligations to so-called reasonable endeavours. Currently, contracts follow laws that, if disputed, should ensure the arrangement agreed by the two parties is enforced.
Making contracts future proof requires what Griffin describes as “presentiation”, which is the process of “looking forward to future circumstances and seeking to bring them back into today’s document”, says Griffin.
“(It is) covering the what-ifs—what if this happens, put in that clause, what if that happens, put in something else,” he adds. “But the unknown unknowns mean you are unlikely to cover the ground you intend to.”