Energy market volatility: contractual and non-contractual adjustment mechanisms - transcript

Transcript

Andres Alfonso: Hello, and welcome to Ashurst Legal Outlook and the latest episode in our Energy Transformed podcast series. My name Andres Alfonso and I am a corporate partner and head of the Madrid energy practice in Spain. I'm joined today by Matthew Saunders, the head of Ashurst Global International Arbitration Practice, and Emma Johnson, a partner in the international arbitration practice based in London.

We are talking today about gas and energy supply and the various contractual and non-contractual ways in which the current market volatility and the spot price increases can be addressed. The three of us have significant experience of advising clients in gas and energy price and negotiations and international arbitrations that result when a negotiated solution is not possible.

So Matthew, this is a particular hot topic at the moment. Can you explain why?

Matthew Saunders: Sure. What we're seeing at the moment in the gas sector is a combination of factors that produce price volatility and produce the perfect storm, if you like, for disputes. Predominantly disputes will be around pricing, but also disputes likely to arise out of attempts by sellers to reduce gas and energy volumes or potentially to get out contractual supply obligations altogether. So it's definitely around supply as well as pricing.

And there are a number of reasons for this. The most recent and most obvious factor, I guess, is Russia's invasion of Ukraine. Russia's the world's third largest supplier of oil and second largest supplier of gas. It was the largest supplier of natural gas to the EU last year, responsible for round about 40% of imports. As we know, Russian individuals and entities are being sanctioned, a number of Russian banks excluded from the Swift payment system. And President Putin certainly has the ability to turn off the supply taps to Europe. Looking back to 2008, 2009, what we call the Russia-Ukraine gas wars, Gazprom then turned down the pressure in pipes transiting Ukraine and that led to a number of big supply and pricing disputes.

Analysts are clear that the risk for supply now is the greatest it's been for, well, probably since Russian exports to Europe really took off in the 1980s. And importantly, the Russian government has yet to make clear what its response to the US and UK oil embargo affecting Russian imports of oil into the UK and the US, what that response will be. So we're waiting to see.

But it's important to know supplier risks are not the only thing likely to give rise to disputes because of soaring demands driven by global economic recovery following COVID, the energy market in particular is already very, very tight and that tightness has been exacerbated, for example, by sanctions impacting Russian vessels that transport energy. If you take some of those vessels out of the market, there's very limited capacity.

So we've got all the ingredients for supply agreements to come under strain, especially where prices are set months or years before, meaning that they're now seriously out of the money compared to what prices can be achieved on the spot markets. All that means, there is a clear incentive not just a seat to adjust prices upwards, but also to explore whether deliveries that are out of the money can be avoided, for example on force majeure grounds. So even if Gazprom does not turn the taps off for exports to Europe, the uncertainty in the market will see prices continuing to rise, and that in turn will cause parties to reconsider their commercial positions.

Andres Alfonso: So we are not just talking here about the scope for sellers' failure to deliver, either because supplies physically cannot be made or because sanctions prevent performance by, or to particular individuals and entities, right?

Matthew Saunders. Yeah. That's the position. Disruptions to the supply of oil and gas are one obvious potential impact of what's happening in Ukraine, but parties may seek to dissolve from contractual obligations irrespective of whether supply problems materialize or not. For example, there could be purchasers who no longer want to, or are able to, do business with sanctioned Russian entities. There could also be sellers of gas and energy who, not withstanding that they're entirely detached from Russia and Ukraine, they can see a benefit in avoiding their obligations to suppliers' fixed prices, that are out of the money; they want to benefit from higher prices achieved in the spot market. So, that's definitely a motivating factor.

Andres Alfonso: So this seems to be in effect a perfect storm for disputes in the energy sector. Emma, what are the main contractual and legal provisions are likely to be in play here? What protection should parties be considering or anticipating being involved?

Emma Johnson: Well, as Matthews said, this is about supply as well as pricing. And so an obvious provision likely to come into play is the type of volume flexibility clause that's often included in long-term supply contracts. It might be that these are increasingly put to use by sellers who want to reduce their exposure to fixed contract prices and instead free up volumes for sale on the spot market. The other obvious contractual provision likely to be in the spotlight is the price reopener provision that's found in many long-term supply contracts.

You've both mentioned the term "perfect storm," and the last perfect storm for pricing disputes occurred in 2008 and 2009. That was prompted by the global financial crisis, liberalization of the European gas market pursuant to the EU's third energy package, and development of hub trading and the resulting decoupling of spot market and oiling prices. Those circumstances saw the many arbitrations arising out of the parties' attempts to reset their contract price using contractual price reopener mechanisms. And to the extent that those mechanisms are still included in long-term supply contracts, there will likely be attempts now by sellers to rely on them.

Andres Alfonso: And if there is a contractual right to reopen the price, are there any specific steps that parties need to be taken or things they should be thinking about?

Emma Johnson: Yeah, definitely. I mean the first priority is really to look at what the clause itself provides. It's not unusual for there to be a requirement to give notice and prior review requests can even become time barred if they're not made by a set point in time or with sufficient speed.

It's also important for parties trying to rely on price reopener provisions to be alive to any contractual obligations to negotiate and whether they might be said to constitute mandate preconditions. If that argument can be made, then a failure to observe those obligations to negotiate might result in the party losing the right to seek a price review or give rise to jurisdiction and admissibility challenges if and when the matter proceeds to a dispute.

The form and content requirements for a price reopener notice will vary from one contract the and next. And so the parties will need to be sure that the relevant trigger event has occurred and can be properly substantiated. Although when you are invoking the clause, you'll want to leave some wiggle room to expand and develop your position as negotiations develop. So it's important to substantiate, but not to provide too much detail.

Early legal and expert input can be key here, both in terms of determining prospects of success, but also informing legal strategy and any commercial discussions that are going to happen before dispute. And as with all disputes being careful to ensure that both relevant evidence is secured and potentially unhelpful documents are not created, which might fall to be disclosed to the counter party if proceedings are started, is something that is very, very important to give careful consideration to you from the outset. That includes taking steps to ensure that settlement offers are covered by legal privilege, to the extent that's available, but it's important to recognize that that might not be possible where evidential issues fall to be determined by reference to certain civil laws in the event of a dispute. So, lots to think about.

Andres Alfonso: I see. So Matthew, if a price reopener negotiation is unsuccessful what's next?

Matthew Saunders: Well, typically the clause will include an arbitration agreement, so the parties will be able to refer the matter to an arbitral tribunal. And there, careful thought needs to be given as to who the arbitrators should be. They need to be properly qualified to understand and determine the dispute together with any procedural issues that might arise. What's important here is that these sorts of disputes tend to be much more about economics than they are about law. So it's important to have arbitrators who are comfortable with economics and economic analysis. There have been cases where parties have been caught by surprise because tribunal have done more than choose between one of the two pricing formerly advocated for by the parties, and instead the tribunals gone on and imposed an entirely new pricing mechanism, which meant not only the pricing provisions, but also, for example, delivery arrangements. So you need to be careful as to what the tribunals are expected to do.

Confidentiality is also particularly important. The price formula and the economics data tends to be super, super confidential. So it's important that tribunals and the lawyers involved are familiar with the mechanisms available to preserve the confidentiality of the evidence during the course of the proceedings.

Andres Alfonso: And worry if there is no contractual prize review, right? Of, if there is such right, but cannot be triggered. Are there other options available in those circumstances?

Emma Johnson: The answer is not a simple one, but there may be. There's no doubt, really, in my mind, that we will see sellers trying to find ways to reduce or extinguish unfavorable supply obligations here where they can't contractually reset the price. Whether or not they can successfully do that will really depend on what the contract says. And importantly, what the law applicable to the commercial relationship provides for.

There are differences here between the common law and the civil law. For contract govern by common laws, particularly English law, much will turn on what the contract itself says. The legal remedy most likely to be applicable is a claim of frustration so that the contract has become impossible to perform or radically different to what the parties had originally envisaged. But frustration, if it is successfully argued, would bring the contract to a complete end. That might not be the most commercially desirable outcome.

It might be possible instead to suspend obligations by arguing that the contract is subject to force majeure. And from an English law perspective, that sort of argument only really exists if there is a contractual force majeure clause, so it turns on the specific wording of the contract. Force majeure isn't a standalone legal doctrine under English law. If there is a force majeure clause, it's likely that a cause or link would be required between the event which constitutes force majeure and the inability of the party relying on it to perform its contractual obligations.

So in general, the fact that performance has become more expensive, or practically or even logistically more challenging, that will not be enough. There have been many attempts over the years to argue economic force majeure, but these have, at least from an English law perspective, not succeeded.

Where civil laws apply such as laws of France, Switzerland, Sweden, it might be possible to rely on a legal doctrine of force majeure in addition to whatever the contract says. And force majeure in the civil laws can be quite different to that under common law systems, with higher thresholds that apply and typically something akin to impossibility of performance is required. So again, a very high threshold.

There might be scope for seeking relief under civil laws on the basis of hardship or "failed assumptions" as it's known in Scandinavian countries, and that would allow a court or tribunal to vary the contractual bargain originally struck between the parties because unforeseeable and extraordinary changes render the performance of the contract greatly more onerous.

The important point to note here is that a law other than the governing law chosen by the parties might be argued to apply on the basis that it is mandatory at the place of performance. So even if the express choice of law in a contract is a common law, that will not necessarily rule out the possibility of some of these civil law doctrines, hardship, for example, being argued to apply as well. So there could be scope for additional remedies if you look beyond the four corners of the contract.

Matthew Saunders: It's also a situation where it might be simply commercially more attractive for some sellers to withhold supplies under their contracts, irrespective of whether there's a legal or contractual basis for doing so. It's what you might call a cynical breach of contract. It might be sellers are prepared to pay cap damages that follow if they can instead sell that much high prices on the spot market. That's obviously a recipe for disputes. If the wording of liability caps isn't clear enough, then at least under English law, they may get away with it, but it's much less likely with some other legal systems, especially civil law ones incorporating obligations of good faith.

And just to mention one other area of law that we might see deployed as a means of resetting contractual obligations of pricing oil, over recent years we've seen increasing moves to use competition law to that effect. So that's an area to keep an eye on.

In short, there's potentially a wide range of arguments that could be used here. Sellers that are blinkered into thinking solely about what their contract or its governing law allows could potentially be missing tricks. And buyers who similarly limit their scope of analysis form the risk of finding themselves caught by surprise.

Andres Alfonso: Thank you both for joining me today.

Emma Johnson: Thanks for having us

Matthew Saunders: And thanks every everybody for listening.

Andres Alfonso: A lot to think about here, and no doubt that this is something that we will be speaking about more in future episodes as the position continues to evolve. Thank you for listening. If you have any questions or comments on this topic, please do get in touch with us. There are very useful materials on this topic available on our website, ashurst.com, where you will also find other podcast episodes in our Energy Transformed series. You can subscribe now on Apple Podcasts, Spotify or your usual podcast platform to make sure you don't miss future episodes. Please feel free to keep the conversation going and leave us a rating or review. Thanks again for listening and goodbye for now.