Good deals gone bad: managing energy contracts in an economically challenging environment

Oil price volatility, the fears of a global economic slowdown, and increasing political tensions and instability resulted in a difficult 2019 for the energy sector. Increasingly, oil and gas companies have had to re-evaluate their investments and make adjustments to ensure a return for investors.

New competitors and technical innovation are also placing pressure on energy companies to adapt and cut costs. Consequently, projects and asset acquisitions are being re-evaluated and spending plans reviewed as oil and gas companies seek to focus their resource on projects which are economically viable.

In this challenging economic environment, contracting parties may be looking for ways to renegotiate or exit an unprofitable or otherwise unfavourable contract. Here we provide our top tips on the issues contracting parties need to consider should they be in that position, or suspect that their counterparties may wish to renegotiate or exit.

1. Check the governing law of the contract

• English law does not recognise any general principle of good faith in the performance of contractual obligations which might require a party to alleviate the consequences of strict compliance with a contract, so as to enable their counterparty to obtain relief from onerous obligations. Despite the stirrings of a doctrine of good faith in some recent cases, this remains the case. As a result, the courts are generally reluctant to allow parties to escape from bad bargains in the absence of express contractual provisions.
• Civil law jurisdictions generally take a more flexible approach, allowing renegotiation in certain circumstances in the event of economic hardship. They are also more willing to require parties to act in good faith in performing their contractual bargain.

2. Is there a hardship clause?

• The contract may include a "hardship clause", or an express provision designed to accommodate changed circumstances, such as a price review clause.
• However, the provisions will need to be clearly defined and sufficiently certain for the clause to be enforceable as a matter of English law. For example, a price review clause will need to define when the review will take place and how the revised price will be calculated, and set out the consequences if an agreement cannot be reached between the parties - for example, referral of the matter to a court or tribunal to determine the revised price. 

3. What are the force majeure provisions?

• The contract may include force majeure provisions, which generally operate to suspend contractual rights and obligations on the occurrence of a force majeure event. A force majeure event is typically defined as an unforeseeable event outside the control of the parties which prevents or delays the affected party's performance of its obligations, but the definition will need to be checked carefully. In contrast to certain civil law jurisdictions, under English law there is no general principle of force majeure, and therefore the availability of force majeure relief will depend on the interpretation of the force majeure clause in the specific contract.
• It is highly unlikely that a decline in oil prices (or the consequences of this) or a global economic slowdown would constitute a force majeure event under most contracts, and often events such as these are specifically excluded from the definition of force majeure.
• However, if these do fall within the definition, careful attention will need to be paid to how the clause works. Often the contract will provide that the parties' obligations are suspended for as long as the force majeure event is continuing, but sometimes clauses incorporate time limits after which, if the force majeure event is still ongoing, one or both parties may have the right to terminate the contract.
• The clause is also likely to impose obligations on the affected party to mitigate the effects of the force majeure event while it is continuing: if this applies, the affected party will need to ensure that it complies with such obligation. Mitigation may involve, for example, seeking to obtain alternative supplies elsewhere.

4. Can the contract be terminated?

Express provisions

• The contract may give one or both parties the right to terminate in certain circumstances. These are often straightforward: for example, the contract may provide that the parties may terminate after a certain date, or, for example, in the context of an oil supply contract, when the seller has delivered the contract quantity to the buyer. If one of these "deadlines" is approaching, it may provide an opportunity for a party to exit the contract. A party exercising any contractual rights to terminate will need to ensure that it complies with the appropriate formalities (e.g. notice provisions).
• In addition, contracts often include a right of termination on breach, which may be restricted to "material breach" or "substantial breach", or simply "any breach". If a party is seeking to exit a contract because it is no longer economic, it may be worth checking to see whether its counterparty has breached the contract in any way and whether that breach gives rise to a contractual right to terminate. Parties should take care, however, to ensure that a breach by their counterparty is sufficient to trigger the right of termination, particularly if the term is not defined in the contract.

At English common law

• As well as any express contractual terms dealing with termination, under English law the parties have rights to terminate at common law where there has been a "repudiatory breach" of contract (unless these have been expressly excluded in the contract).
• A breach of a condition of the contract (a fundamental term), or of an innominate term (a term which is not expressed to be either a condition or a warranty) which goes "to the root" of the contract, will be a repudiatory breach. This will entitle the other party to terminate with immediate effect if it elects to do so. Alternatively, the innocent party may "affirm" the contract and keep it in existence. If a counterparty has committed a repudiatory breach of contract, careful consideration is required before terminating: it may ultimately be in both parties' best interests to continue with the contract.
• As with the exercise of contractual termination rights, it is very important to ensure that the other party's breach does in fact constitute a repudiatory breach before the termination right is exercised. This is because, if a party terminates a contract in the absence of a repudiatory breach, it will have wrongfully terminated the contract, which will in itself constitute a repudiatory breach and mean that the terminating party may be liable for damages.
• A related point to be aware of is that any perceived intention by a party to not be bound by the contract's terms could be deemed by the other party to be a repudiatory breach of contract. Therefore, parties should take care if seeking to renegotiate terms to ensure that the desire to renegotiate is not viewed by the other party as evidence of a lack of intention to be bound by the contract, as this may expose the party seeking to renegotiate to termination for repudiatory breach.

5. Is the contract frustrated?

• In certain very limited circumstances it may be possible for a party to argue that the contract is frustrated. The doctrine of frustration operates to discharge the contract automatically, excusing both parties from their future obligations where a frustrating event occurs.
• A frustrating event is one which:

a) occurs after the contract has been formed;

b) is so fundamental as to be regarded both as striking at the root of the contract and as entirely beyond what was contemplated by the parties when they entered the contract;

c)is not the fault of either party; and

d) renders further performance of the contract impossible, illegal, or radically different from that contemplated by the parties at the time the contract was formed.

• This is a high threshold. Case law has established that a contract will not be discharged by frustration where a contract is simply more expensive to perform ; there are changes in economic conditions ; or where the seller under a sale of goods contract is let down by its own supplier . It therefore seems unlikely that circumstances could arise where a decline in the oil price would be considered to amount to an event which frustrates a contract.

6. Be prepared

• It is advisable for parties to review their existing contracts even if they are not currently in a position where they wish to exit a contract, or suspect that their counterparty might wish to exit. This will help to identify any potential issues or gaps as early as possible and enable parties to take any steps necessary to avoid or mitigate problems which may arise in the future.

• As a general rule, care should be taken to comply with all contract formalities (e.g. in relation to time limits and notice periods). If a party is seeking to exit a contract, failure to comply with contract formalities may mean that it loses some of the rights and opportunities mentioned above. Conversely, if a party wishes to preserve a contract which its counterparty wishes to exit, the party should ensure that it does not inadvertently breach the contract, giving the other party an opportunity to terminate.

• If a party is in a position where its counterparty is struggling to perform its obligations, the party should consider whether renegotiating certain terms of the contract or electing to affirm a repudiatory breach may be preferable to a situation where the counterparty is forced into insolvency, which may drastically limit recovery options.

Author: Tom Cummins, Partner