LNG Pricing Disputes: The lessons from Europe

According to the Oxford Institute for Energy Studies (OIES), one of the best informed observers of global gas markets, the LNG industry is on the verge of "radical" and "fundamental" change.  In its September 2016 publication, "The Great Reconfiguration", the OIES notes that dramatic changes are set to overturn more than five decades of industry practice, including – crucially – the model of LNG long-term sale and purchase agreements (SPAs) where pricing is linked to oil prices.  The OIES cites two main potential causes of the pending changes: significant new LNG export capacity, which is due to come on stream in various parts of the world, and a slowing down of Asian demand.

Similarly, in autumn 2016, the LNG Journal noted (by reference to the latest analysis from the International Energy Agency) that: "The oversupply situation in liquefied natural gas markets that emerged in 2015 is worsening in 2016 and will not substantially improve until 2019 at the earliest".

The excess of LNG resulting from such supply-demand imbalance is expected to affect both the pricing and other contractual dynamics in long-term LNG SPAs (including, in particular, terms relating to flexibility).

The experience of the European natural gas markets over the past decade shows that any significant attempts to "reconfigure" existing contractual arrangements are likely to give rise to disputes.  Two of the most likely subjects for dispute are those of pricing and related contractual flexibility, particularly as to volume, since those factors go to the core of whether a contract is profitable or not.

The experience of European natural gas markets since 2008 has been one of a dramatic upswing in the number of disputes, many of which have ended up in international arbitration, arising from the invoking of "price reopener" clauses in gas SPAs.  The effect of such widespread recourse to arbitration mechanisms has been the resetting of prices by arbitration tribunals and, on occasion, significant changes being made to other elements of pricing formulae which has provoked controversy as to whether such changes are properly within an arbitration tribunal's jurisdiction.

The considerably adversarial nature of the arbitration process has also impacted upon the historically consensus-driven approach that has prevailed in the gas industry, which has a relatively small number of players and, until recently, has seen shared assumptions as to what is an acceptable "modus operandi" for commercial and contractual negotiation.

There are a number of lessons that can be drawn from the European natural gas experience and applied to LNG renegotiations and disputes in other regions. There are, of course, many significant differences between the contracting styles and commercial contexts that apply to natural gas sales arrangements in the European market and LNG sales arrangements in the global markets, but there are enough features in common and sufficient similarities of approach to the resolution of disputes for the study and analysis of the European gas market experience potentially to pay significant dividends – the lessons that can be drawn may maximise a party's chances of success in both renegotiations and disputes.

Europe's "perfect storm"

The European experience of an upswing in gas price arbitration came about by way of a "perfect storm" emerging from the global financial crisis of 2008.  The key elements were:

• liberalisation of the European gas market pursuant to the EU's Third Energy Package (combined with enforcement steps being taken by national regulators), which led to the development of gas trading hubs and the creation of both physical and administrative infrastructure capable of supporting spot trading of gas and thus an increase in gas-to-gas competition;
• a reduction in demand for gas arising from the slowdown of the European economy associated with the global financial crisis;
• a policy-driven increase in the role of renewables in the generating mix;
• technological developments supporting the availability of gas from non-conventional sources, leading to an increase in supply; and
• a resulting "decoupling" of spot market prices for gas from traditional oil-linked prices (where it had been historical practice to link the price of gas to that of alternative fuels, particularly oil products).

As a result, players sought to renegotiate the price at which they had committed – often for a lengthy period of time – to take gas.  In many cases, negotiations gave way to arbitration.

Although there exists a significant diversity of approach (extending to gas SPAs without any price reopener provision and some that contain only contractual hardship clauses), the European gas arbitration community has largely adopted a common approach to resolving these pricing disputes.  It is this that enables wider lessons to be taken as to how parties dealing with LNG disputes may benefit.

Applicable legal principles

Although no single standard exists for European gas price reopener clauses, there are significant similarities in the approach to their drafting and interpretation.  It is relevant that long-term gas sales agreements are predominantly continental European creatures, with few UK long-term contracts because of the much earlier liberalisation of UK gas markets.  The effect of this is that the gas price arbitration world has been significantly influenced by civil law.

This is significant because it means that the civil law approach to issues such as document production, or the extent of a tribunal's jurisdiction to amend contractual provisions other than those relating simply to price, may prevail in LNG disputes, even where the governing law is not a civil law one.

Contracts are often vague as to how far a party is under an obligation to negotiate "in good faith" and what the implications may be if it can be shown not to have done so (it is relevant that civil law contract regimes may impose an obligation to negotiate in good faith even if one is not expressly provided for in the contract).

Revision of price (and other contract conditions) may also be available under certain civil law regimes where they have been chosen as the governing law of the contract.  Certain civil law regimes grant a right to adjust the contractual bargain where changes unforeseeable at the time the contract was entered into have the effect of causing "unreasonable hardship".  In extreme cases, the contract may be held to be ineffective as a whole.  Such contractual rights are perhaps most clearly available in the Scandinavian context, applying section 36 of the relevant contracts act and the Scandinavian contractual doctrine of failed assumptions. Although such laws may be less commonly applicable in the LNG world, it pays to understand their implications.

Specific price reopener lessons to apply

Obligations to negotiate

One key lesson that can be taken from the European gas pricing experience is the significance of express obligations to negotiate.  It will be particularly important that negotiation obligations are adhered to where the fact of negotiation having taken place may be a contractual precondition to commencing an arbitration.  To run an arbitration and only at the end discover there was no jurisdiction, because a necessary precondition to the commencement of the arbitration process was not met, may prove to be an extremely expensive mistake.

Whether or not the governing contract law recognises the existence of an obligation to negotiate, or dismisses it as an unenforceable "agreement to agree", will commonly be a significant distinction between civil and common law governing laws.

Evidence of trigger

Another lesson is the fact that a party will commonly be expected to provide a measure of support for its assertion that a trigger for the resetting of a price has been met, including some degree of clarification as to the relevant market in which the inability to market gas economically has arisen.  The contract itself may be vague on the level of substantiation to be given, but the applicable law may provide guidance.

Confidentiality

A further lesson is that close attention should be paid to requirements of confidentiality.  Pricing formulae are contractual terms of the highest commercial sensitivity.  Does the contract provide for material to be kept confidential? What degree of confidentiality will attach to documents that are provided to lawyers and experts or to the tribunal? What is the status of documents produced under compulsion through a document production exercise? How far can commercial secrecy be an effective objection if the counterparty makes an application for production of documents to the tribunal?

The key lesson is that these points should either be agreed with the counterparty or be the subject of an early procedural ruling from an arbitration tribunal.  That way surprises can be avoided.

Economic evidence

Of prime importance is the need carefully to prepare the economic evidence that supports the claim (or which will be needed to respond to an anticipated claim), particularly expert economic evidence.  There is a finite pool of experienced testifying economics experts and instructing the right team early on can bring significant advantages.  It would be folly to commence a price review without understanding how far the economic analysis supports it.

Alongside economics experts, it may be necessary to adduce factual testimony or possibly expert testimony as to industry practice – experience suggests there is a particularly limited pool of industry experts with relevant recent experience.  Tribunals may find evidence from an experienced commercial negotiator or contracts manager more compelling than that from a "hired gun" consultant.

Early input from legal counsel

From the outset, there should be input from counsel experienced in gas pricing disputes – their full involvement from an early stage will assist in establishing and maintaining legal privilege (thus protecting documents from compulsory production) and will ensure that the correct early – and key – decisions are taken.

The attitude of arbitrators

One result of the growth in gas price arbitrations has been the establishment of a "community" of legal and industry practitioners with shared experience of the interpretation of relevant clauses and the running of arbitrations.  This "community" comprises not only specialist arbitration lawyers in leading arbitration practices, but also expert economists and a "cadre" of arbitrators who have experience in disputes often involving much more economic than legal controversy and which consequently require a degree of familiarity with economic principles.

It is quite likely that these same arbitrators – because of their gas sector experience – will be appointed and that – at least initially – they will adopt similar approaches to those developed in the European gas pricing context.

Alongside the choice of arbitration counsel, thought should be given from the outset as to the choice of arbitrator to be nominated and to preferred candidates for chairman.

Points to consider include whether a common or civil law background is preferred and whether previous gas pricing experience, or experience of economics-based disputes, is necessary/desired.  Careful research may provide useful intelligence as to an arbitrator's likely attitude to issues such as document production – whether it will be restricted to those issues upon which a requesting party bears the burden of proof or whether it will be more widely available (for example, where a legitimate line of inquiry involving a defined and narrow class of documents is established).

Price review or rewriting the parties' bargain?

A more fundamental issue worthy of research is the attitude an arbitrator is likely to take to his or her jurisdiction; does it extend to merely adjusting the price or is there a risk that the arbitrator will go further and rewrite other elements of the price formula? Arbitration agreements are commonly imprecise as to the jurisdiction that is granted to an arbitration tribunal.  This question is normally of little significance given their role is clearly to adjudicate the dispute, but the position is more complex (and controversial) in a pricing dispute.

It is important to consider how far the right to set a new price extends and whether it encompasses the arbitrator being able to change other elements of the pricing arrangements; for example, the point of reference from a basket of oil products to prices achieved on a particular gas trading hub.  Critics contend that such actions amount to much more than price adjustment and represent impermissible rewriting of the parties' contractual bargain.  Proponents contend that only through such steps can tribunals properly take account of changed circumstances as fundamental as the decoupling of gas prices from oil pricing.

Parties are well advised to agree at the outset of an arbitration whether they actually wish to grant such wide-reaching powers to a tribunal comprised of arbitration lawyers who may have negligible commercial experience as to the implications of the changes they impose.

There is also sense in clarifying how far back a tribunal may look – must it restrict its analysis of evidence as to market changes to that available between the date of the last review and the invoking of the current process or may it also look at information available since? To what extent is the future relevant and is evidence required as to the likely impact of the changes relied upon in the future? Should the tribunal be aiming to set a price that renders the contract economically viable until the next point at which it can be reopened?

Looking forwards

It may very well be the case that in due course those responsible for adjudicating LNG disputes "steer their own course" and develop approaches unique to the LNG market. However, at least initially, it is likely that approaches similar to those experienced in European natural gas pricing disputes will prevail.  It is because of the "proving ground" it has become for gas disputes that lessons from the European gas pricing experience can usefully be applied in order to maximise the chances of winning.