21st February 2024

The Russia-Ukraine conflict has exacerbated the global energy supply crisis and brought about structural changes in the natural gas market. Governments around the world, including in Europe, are prioritising the import of liquefied natural gas (LNG) and rapid construction of LNG terminals to enhance energy security and protect their economies from the impact of high energy costs.

Many energy companies, meanwhile, prefer signing longer-term procurement contracts to ensure reliable supply and avoid price surges.

This article analyses measures that domestic LNG import companies (buyers) can adopt to prevent business risks associated with price fluctuations when arranging long-term LNG procurement, starting with LNG long-term contracts.

PAY AND SUPPLY CLAUSES

commercial risks from LNG price fluctuations
Wang Jihong
Partner
Zhong Lun Law Firm

One of the reasons buyers and resource suppliers (sellers) sign LNG long-term contracts is to lock in LNG prices and avoid significant increases in procurement costs due to spot price fluctuations.

However, in many LNG long-term contracts that the authors have dealt with, most of the clauses aim to regulate the buyer’s payment obligations and protect the seller’s rights from downstream market fluctuations.

The more typical contract clause, known as the take-or-pay mechanism, is: “During each contract year, the buyer shall have an absolute and irrevocable obligation to take and pay for the annual contract quantity of goods at the agreed price. If the buyer fails to take any contract quantity, the seller may cancel the delivery of such quantity, and the buyer shall pay the price as agreed in the contract.”

The premise of the buyer’s take-or-pay mechanism is the seller’s supply-or-pay mechanism, and both the buyer’s payment obligation and seller’s supply obligation shall be absolute and relative at the same time.

In practice, considering that LNG is not as easy to enforce as other general goods or currencies, if the seller breaches the contract and cannot supply the goods in full, the buyer will not only suffer losses – due to the inability to obtain alternative resources in the short term – but also make it difficult to force the seller to perform the delivery obligation through dispute resolution methods.

Therefore, the LNG long-term contract should clearly specify the seller’s supply obligation, and liability for breach of contract to prevent the seller from reducing the supply of LNG resources under the long-term contract during a certain period due to the increase in spot market prices.

PRICE TERMS

commercial risks from LNG price fluctuations
Liang Danni
Associate
Zhong Lun Law Firm

In most of China’s long-term LNG import contracts, the majority are linked to the price of Brent crude oil index or Japan Crude Cocktail (JCC). A small number of contracts are linked to the US Henry Hub (HH) index, the Dutch TTF Natural Gas Futures index, and the Asian Platts JKM index.

Huge fluctuations of various indexes pose a severe challenge to buyers in controlling their procurement costs.

When signing non-fixed price LNG long-term contracts with sellers, buyers can effectively control their procurement costs by designing price lock-in clauses through negotiation and consultation in the final contract text.

Price lock-in clauses can be achieved in two ways: (1) by making special arrangements for the price formula and hypothetical conditions; and
(2) by clearly stating the buyer’s right to convert the indexed price to a fixed price before the LNG transport ship arrives at the port for unloading.

PRICE FORMULAS, ASSUMPTIONS

Buyers can negotiate with sellers to consider and estimate the LNG market comprehensively, and fix the price formula to a certain coefficient value – instead of directly linking it to the price index – thus controlling their procurement costs.

If the seller finds it difficult to agree to this arrangement, the buyer can further propose to design the price formula into different categories, set LNG prices in different price intervals, and correspond to different price index calculation methods, thereby indirectly fixing the procurement price.

Buyers can also comprehensively evaluate the downstream buyers and gas-fired power plants’ electricity price factors from a commercial perspective and explicitly state in the price terms that in the event of an increase in electricity prices, the buyer can share the profits with the seller at a certain coefficient/proportion, thereby increasing negotiation leverage for the seller to agree to the lock-in arrangement.

INDEX-LINKED TO FIXED PRICES

Buyers can also choose to include a clause giving them the right to convert index-linked prices into fixed prices before the LNG vessel arrives at the port for unloading. Resources linked to price index can then be priced and settled at a fixed price, allowing buyers to control their procurement costs.

In practice, after friendly negotiations, the buyer issues a locking instruction (including the locked price and quantity), and the seller locks in the price within a certain time and confirms the result.

If the seller locks in the price within the specified time, the final settlement will be based on the locked price and quantity. If the seller fails to lock in the price within the specified time, the two parties will negotiate whether to lock in the price based on the latest market conditions, or void the locking.

By setting up locking clauses, any price index risks can be effectively managed through the content of the trading contract, and the operation is relatively simple.

KEY TAKEAWAYS

In addition to the above-mentioned measures, LNG long-term contracts also include other clauses that indirectly achieve the goal of preventing and controlling price fluctuations.

For example, by setting up clauses such as delivery volume uplifts, recall and replenishment, the buyer can increase the actual delivery volume of the annual contract, ensure sufficient downstream sources, and better cope with sudden price fluctuations.

Given the current international situation, market conditions, and important role of natural gas in the context of the “dual carbon” target, LNG long-term contracts are undoubtedly an important way for Chinese energy companies to secure stable natural gas supplies in the future.

Since effective prevention and control of the commercial risks brought about by price fluctuations has become a top priority, it is recommended that buyers engage professional consulting firms to design these measures rigorously and meticulously to make more prudent business decisions and also maximise commercial benefits.

Wang Jihong is a partner and Liang Danni is an associate at Zhong Lun Law Firm

Zhong Lun Law Firm

22-31/F, South Tower of CP Center

20 Jin He East Avenue

Beijing 100020, China

Tel: +86 10 5957 2288

Fax: +86 10 6568 1022

E-mail:

[email protected]

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www.zhonglun.com

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