Global asset management quarterly: A global briefing on developments and market trends
Welcome to the thirteenth edition of Global asset management quarterly.
A series of major geopolitical events coupled with significant advances in technology have led to dramatic changes to the global gas industry over the past 20 years. These changes have spawned their own particular class of legal dispute amongst buyers and sellers of natural gas – the price review arbitration. However, with liquid hubs for natural gas now well-established in the US and Europe, at least, some commentators have argued that the end of the price review arbitration is nigh. In this article, we look at the history of price review arbitrations, and consider the outlook for the future.
Historically, buyers and sellers of pipeline gas and liquefied natural gas (LNG) would enter into long term take or pay contracts. There were incentives for both parties to use this model. Sellers needed buyers who were willing to commit to purchase fixed quantities of gas over the life of a project in order to secure cash flow and support the economics of the capital intensive projects needed to bring gas on-stream. In turn, buyers needed security of supply in order to meet customer demand in their home market.
When it came to contract price, for the buyer, the price it paid to the seller needed to reflect the price it would receive from customers or ‘end users’ in its home market, where gas would be competing with other fuels such as coal and oil. For the seller, there needed to be sufficient margin between its costs of production and the downstream price for it to make a profit. Base prices were therefore typically set by reference to the end user price, plus the costs of distribution, together with an indexation element to allow the price to adjust over the life of the contract. As there was no “market price” for natural gas at that time, parties had to consider other metrics for indexation.
The answer was to use a competing fuel, such as oil or coal for which there were established and stable markets, as a proxy for the value of the natural gas in the indexation element of the pricing formulae. Even with indexation, however, the parties recognized that there may be changes to the gas market that would not be reflected in the competitor fuel index but which could affect the bottom line for either the buyer or seller. A further solution was therefore required and this came in the form of a price review clause, which permitted changes to the contract price in specified circumstances.
Whilst there is no standard form price review clause, clauses will typically include a number of key characteristics
Price reviews exercises are particularly prone to dispute for a number of reasons.
When drafting a price review clause there is a mutual interest in using general wording. The parties do not know who will want to trigger a review and the clause needs to be broad enough to respond to events which, at the point of drafting, are often outside of the parties’ knowledge. With this generality, however, inevitably disputes arise as to the scope and application of the clause when a party seeks a review.
As these disputes tend then to be referred to private arbitration, there is a paucity of precedent on interpretation of price review clauses. This makes it difficult for parties to predict how a tribunal might construe the wording and therefore for disputes to be settled, rather than progressed to arbitration.
There is also a lot of money at stake. Being the losing party in a price review can be very costly – just a small adjustment to the price can run into the hundreds of millions, if not billions, of dollars over the term of a contract undermining the project economics altogether. With stakes this high it can be worth pursuing arbitration, even where prospects of success are uncertain.
Price review arbitrations are also a unique class of disputes. The tribunal is being asked to determine a quite different question to a standard claim. Neither party is in breach of contract or committed a wrong; they simply cannot agree on how a provision of the contract should operate and are effectively asking the tribunal to ‘rewrite’ the deal on price to reflect the changed circumstances. The quirks of price review therefore, call for specialist counsel and arbitrators who can handle technical economic, quantum and accounting matters, together with the legal issues, and who are willing to step into the realm of commercial contract negotiation.
The first round of price review arbitrations followed the liberalization of the European gas market in the late 1990s. Whilst liberalization proceeded in a piecemeal fashion, the shift away from single, monopolistic buyers of gas (who were often state owned utilities), to markets where multiple buyers were competing for downstream customers (i.e. gas on gas competition) disrupted the market, with the downstream price being dictated by the new market dynamics at play in the end-user state. Although this was good news for customers who saw their gas bills come down, buyers who were tied into long-term sale and purchase agreements linked to oil prices, which they had entered into when they had a monopoly in their home market, were now being undercut by new entrants to the gas market jostling to secure customers, and seeing their revenues tumble.
This disconnect between the upstream and downstream gas price spawned the first phase of price review arbitrations as buyers sought downward revisions to their pricing to reflect the emergence of competition in the market.
A decade later, following a sustained period of booming commodities prices, the global economic crisis hit. This led to a dramatic decline in demand for gas just at a time when new supplies, including huge volumes of unexpected US shale gas, were being brought online. This led to a supply glut and the diversion of LNG away from the US (historically a net importer) into Europe. With Europe being treated effectively as a dumping ground, the then nascent European hubs were suddenly flooded with large volumes of gas.
The upside of this was a boom in trading which allowed European gas hubs to start maturing but it also triggered a spate of buyer initiated price review arbitrations with buyers seeking downward revisions to their long term oil linked deals.
The most recent round of price reviews has been prompted by the desire of European buyers to move away from oil indexation to pricing based on European gas hub prices. The volumes being traded on these platforms and the stability of pricing is now such that buyers consider them to be a more reliable price indicator than competitor fuel indices, such as oil and coal.
Buyers therefore commenced price reviews to seek revision to the pricing formulae to replace oil indexation with gas hub indexation. Whilst this is a fundamental change to the commercial deal originally struck in these long terms contracts, it is a move which has largely been accepted by the major gas suppliers into Europe who recognise the structural changes in this market.
In Europe, at least, some now argue that where the pricing formulae is linked to a European gas hub, price review clauses are unnecessary as the contract price should always track the market and there is no risk of divergence as there was for oil-linked contracts. If that proves to be correct, price review arbitrations in Europe may die out. However, even where there is hub pricing, there is still the risk that the hub price and the price in the end users’ specific market may diverge (particularly given the destination flexibility offered by LNG where the hub reference could be geographically distant from the buyer’s market) and this may trigger price review disputes.
Looking further afield, the European story has not been mirrored in the Asian gas market, which is a huge importer of natural gas and particularly LNG, which will increase as China ceases to use coal for power generation. There pricing largely remains linked to oil indexation, markets are monopolistic and prices reflect supply costs. This region could be the next hotbed for price reviews as Asian buyers look to the lower prices in Europe, and contemplate what they can do to improve the terms of their deals.
Welcome to the thirteenth edition of Global asset management quarterly.
If COP25, 2019 were to be summarized in a word, it would be ‘pathways’ – shorthand for the social, economic and technological choices that must be made in the near term in order to avoid catastrophic climate change.