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Editorial comment

As a result of the events in Ukraine as well as other market trends, the price of natural gas and LNG has increased significantly compared to 2020. The recent increase in the volatility of LNG pricing has caused certain counterparties that supply LNG to engage, or at least consider, opportunistic breaches. Sidley Austin examines the deliver or pay (DoP) structure typically underpinning most LNG supply arrangements (both long-term and under master agreements) and mitigating factors that can be taken by the buyer to ensure the delivery of the LNG cargo.

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In an effort to limit uncapped liability for the failure to supply LNG, the typical LNG supply arrangement has a provision, DoP, that limits the liability of the seller to the payment of some form of damages as an alternative means of performance (i.e., it is not a breach to fail to deliver as long as the payment is made). The provision has two basic forms:

  • Actual damages – which measure the actual damages incurred by the buyer to purchase a replacement cargo of LNG or to acquire natural gas to replace the LNG that buyer failed to deliver, subject to an aggregate cap on liability. The principal downside of this approach is that the buyer is required to acquire an alternative cargo and demonstrate the damages actually incurred by opening up its books to the seller, which is generally poorly received by buyers.
  • Liquidated damages – which serve as a reasonable estimate of the potential future damages, calculated based upon a fixed percentage of the price of the undelivered cargo (e.g., from 35% of the value of a cargo up to 100% of the cargo). As long as the percentage is acceptable, buyers prefer these provisions because they are not required to demonstrate any actual cost incurred.
One of the reasons for a significant mismatch between buyer and seller is that the cost to the seller to acquire or produce a cargo of LNG is often completely unrelated to the sales price for LNG paid by the buyer under the LNG supply arrangement. In times of relative pricing stability, having a DoP provision that represents the approximate value of an alternative cargo of LNG is a reasonable allocation of risk. The buyer could easily find a replacement cargo of LNG and be kept whole by the seller under the DoP provision. However, problems arise when LNG prices becomes very volatile, with the DoP provision creating an option that would permit a seller to engage in an opportunistic breach. For example, if the price of LNG under the agreement is US$8.50/million Btu, but the spot price for a cargo of LNG is US$28.00/million Btu, it is simple to see the financial incentive to the seller. The DoP provision will cap the damages payable (e.g., 100% of the cargo price under the contract) and allow the seller a substantial profit for redirecting the cargo to a third party. Assuming that the buyer in fact needs the LNG as a party to the energy matrix of the country, what can a buyer do to mitigate or reduce the risk of opportunistic breaches?
The vast majority of LNG supply arrangements are governed by either New York law or English law. Unfortunately, the case law in both jurisdictions is rather unhelpful. Both jurisdictions recognise the concept of an efficient breach. The reason a party fails to perform is irrelevant for determining damages. There is no substantive difference between failing to deliver a cargo because (a) the liquefaction facility was unavailable and (b) the seller found a third party willing to pay a higher price. While the reasons are very different, the results to the buyer are the same. This legal construct makes it very difficult to structure contracts to differentiate between breaches that are not the fault of the seller and breaches resulting from opportunistic sales by the seller to a third party.
Notwithstanding these limitations, parties often try to develop a scheme that will result in different levels of damages depending upon the reason for the failure to deliver. These clauses are in addition to the traditional DoP provisions. Unfortunately, courts may reject these approaches as being inconsistent with current case law. Such possible solutions to curtail opportunistic behaviour by sellers include:
  • Willful breach – perhaps one of the most common approaches is a provision that says if the seller intentionally fails to deliver a cargo of LNG, then the limit on liability does not apply (i.e., there is no cap on liability). The deterrent effect is probably more the lack of certainty on the part of the potential seller in calculating potential damages than any solid legal foundation.
  • Disgorgement – a legal concept that would require the seller to disgorge or give up all profits to the buyer made on the sale of a cargo to a third party. If the seller in fact fails to deliver a cargo, then the seller is no worse off. However, if the seller actually does sell a cargo to a third party, then all profits are delivered to the buyer to discourage any opportunistic breach by the seller. Again, this provision provides uncertainty (i.e., it may or may not be enforceable), which should help to create a further obstacle to any opportunistic breach.
  • Escalating liquidated damages – if the seller fails to deliver one cargo, the DoP liquidated damages are equal to the percentage of the value of the cargo (e.g., 100%). If there are two consecutive undelivered cargos, then the liquidated damages are increased to 150% of the value of the cargo. If there are three consecutive failures, the liquidated damages payable as a DoP payment are 200% of the value of the cargo, up to a right to terminate. This escalation helps to greatly reduce the financial incentives to sell to a third party. This approach does create difficulty for a seller who is experiencing operational difficulties by theoretically exposing the seller to increasing damages. However, the vast majority of those instances can be addressed by a well drafted force majeure clause or other recognised excuses to performance.
There is no magic bullet or way to ensure that the cargo that the buyer intended to purchase will in fact be delivered by the seller. In determining the appropriate allocation of risks in a volatile LNG market, the parties should consider taking into account the price of LNG and the impact on a party for failing to receive a cargo in a high price environment. It would make logical sense for the damages payable under a DOP regime to reflect the actual market price (in addition to the contract price). In this way, the risk allocation more reasonably follows the intent of the parties regarding the supply of LNG.