Non-Delivery Under LNG Sale Contracts – Managing The Risks.
The spike in gas prices following the Russian invasion of Ukraine highlighted the issues that can arise under long-term LNG sale and purchase agreements in the face of extreme divergence between market and contract prices, cargo shortages, and force majeure events.
In recent years, shorter-term LNG contracts and spot contracts have become more common. Nonetheless, any LNG sale contract that commits the parties to a relationship over a period of years will need careful drafting with a view to ensuring that its provisions reflect the allocation of risk that the parties intend.
In this article, we look at some standard LNG sale contract clauses and consider how they deal with non-delivery of cargoes.
Liquidated damages
An LNG sale contract will often incorporate a liquidated damages provision covering non-delivery. Such provisions can be useful for providing certainty as to what can be claimed and may therefore reduce the scope for disputes. However, the buyer will want to think carefully about the extent to which it excludes or caps its recoverable damages.
Generally speaking, where contractual provisions have been freely negotiated between commercial parties, they will be upheld even if it later transpires that one party has made what turns out to be a bad bargain. While contracting parties are not assumed to have lightly given away their legal rights, if that is the clear effect of the contractual clauses then the Court or an arbitral tribunal will not be inclined to override what has been expressly agreed.
Liquidated damages provisions can vary from contract to contract. For example, the clause might require the seller to pay the spot price for the shortfall quantity, in which case the seller will not have benefitted if it has deliberately reneged on its contractual commitment in order to sell the cargo elsewhere.
On the other hand (and more commonly), the contract might provide for damages to be calculated on the basis of a percentage of the price agreed for the cargo. It may even provide for a calculation by reference to an index for an entirely different product (e.g. gasoil). This might not reflect the actual loss sustained by the buyer. That is especially the case if an index for a different product is used and gas prices have diverged from other energy prices. The mechanism for calculating damages may also vary depending on whether or not the buyer replaces the non-delivered LNG.
The buyer may benefit from a liquidated damages clause because it will not need to prove that it has in fact incurred any losses or that it mitigated any such losses. Absent express contractual clauses dealing with recoverable damages, the buyer would have to prove both actual loss (usually supported by expert and market evidence and adequate documentary evidence) as well as reasonable efforts to reduce its loss, for example by sourcing substitute cargoes.
However, where the shortfall amount is not the buyer’s only loss, there may be an issue as to whether it can recover its other losses under the contract or whether the liquidated damages provision is its “sole and exclusive” remedy. If the latter, then the buyer may find itself with unrecoverable losses. The contract may also provide for a general limitation of liability, precluding the recovery of damages such as loss of profit and indirect or consequential loss.
Wilful default/gross negligence
It is rare that an exclusion clause would be taken to cover malicious, wilful, or reckless conduct. That would require clear wording which is highly unlikely to be provided for. This principle may also apply to the liquidated damages under an LNG sale contract if the regime effectively operates as an exclusion clause.
Some liquidated damages regimes also expressly provide a carve-out for wilful default and/or gross negligence. Depending on the wording used and the scope of such a provision, a deliberate breach – where sufficiently proven – could invalidate a damages cap or limitation/exclusion clause.
This could deter a seller from taking advantage of market conditions to default on its contractual obligation to deliver the cargo and sell it elsewhere. Nevertheless, the buyer should pay attention to the contractual definition of wilful misconduct, in order to ensure that it applies to the damages regime for non-deliveries and that it is not so narrow it is irrelevant in most circumstances (e.g. if defined as disregard as to safety or property).
Termination
A buyer faced with default by the seller may elect to terminate the contract in accordance with its default provisions or for repudiatory breach at law. In principle, this would entitle the buyer to declare the contract at an end and seek damages.
However, the buyer should be careful to comply with any contractual process for termination (e.g. by giving the requisite notices to remedy). It should not jump the gun and terminate the contract prematurely or withhold its own contractual performance (e.g. payment) too soon. Otherwise, it may find that it has itself committed repudiatory breach and is liable for damages.
If the contract is terminated, there may be a question as to whether the liquidated damages regime survives and applies to cargoes that would have been due for delivery post-termination. If it does not, the buyer may only be entitled to recover loss of bargain damages for such cargoes. That could work in its favour (if market prices are much higher than the contract price) or against it (if it will struggle to prove the losses that it has incurred). If the parties want the liquidated damages regime to survive termination, they should therefore ensure that the contract provides for that.
Force majeure
The contract will likely incorporate a force majeure (FM) provision. The scope and effect of that will depend on the wording used and the events that are covered by the clause. It is also important to consider how and to what extent the FM clause interacts with the liquidated damages regime and/or any limitation or exclusion clause.
Endeavours clauses
The contract may oblige the seller to use reasonable endeavours to source alternative supplies if it cannot deliver the cargo in time. The scope and extent of that obligation (i.e. how far the seller has to go) will differ depending on whether the clause provides for reasonable endeavours, all reasonable endeavours, or best endeavours.
In general terms, a reasonable endeavours obligation does not require the seller to subordinate its own financial interests. By contrast, an obligation to use best endeavours would normally be taken to require that the seller, if necessary, subordinates its own financial interests in order to source an alternative supply.
Conclusion
Given the market conditions and price fluctuations of the past few years, it is important for LNG traders to carefully negotiate the terms of their sale contracts and ensure they understand their contractual rights and obligations in the event of non-delivery.
For further information, please contact:
John McNeilly, Partner, Hill Dickinson
john.mcneilly@hilldickinson.com
