Since almost the inception of the LNG industry, the “take-or-pay” contract structure has become perhaps the defining characteristic of long-term LNG sale and purchase agreements (SPAs). The benefits of the traditional take-or-pay structure are well-known to the LNG industry and international project lenders because of its generation of a stable and predictable revenue stream to support a project financing.
Despite the overwhelming historical LNG industry acceptance of traditional take-or-pay contracts, it is important to understand that this contract structure also carries a potential set of drawbacks and weakness. In some cases, these drawbacks and weaknesses have not been fully understood or considered by the contracting parties or the project lenders. Indeed, in many cases the traditional take-or-pay structure is accepted simply as an orthodoxy in an LNG SPA setting, with little question by either party or the financiers as to whether there may be a more desirable arrangement.
In the face of a quickly changing LNG industry driven by a plethora of new LNG projects, a significant number of new industry entrants (including many so-called “portfolio” suppliers), and increasing seller requirements for debt financing competing with increasing buyer demands for contractual flexibility, it is worth taking some time to step back and re-evaluate the role of the traditional take-or-pay contract structure in today’s evolving LNG marketplace. While the take-or-pay contract regime will likely remain the mainstay of long-term SPAs for greenfield LNG projects in the near future, there are signs that market forces are causing the traditional take-or-pay regime to be replaced, in an increasing number of instances, with a “cargo-by-cargo” delivery and receipt regime that differs in a number of significant areas from the standard take-or-pay contract structure.
What is a Take-or-pay Obligation?1
Before we introduce and analyze this new2 “cargo-by-cargo” contract structure, we will first review the traditional take-or-pay structure. In very simple terms, the take-or-pay obligation is an obligation by the buyer to either take-or-pay for a certain quantity, with such obligation typically being measured over the course of the relevant contract year.3 By way of background, a typical LNG SPA contains a clause that specifies the “annual contract quantity” or “ACQ”, which is the total quantity of LNG that the seller may be required to sell and deliver, and the buyer may be required to take and receive, over the course of each contract year. The ACQ is then subject to adjustment by certain quantities (typically including quantities in respect of which the buyer is exercising its upward or downward flexibility rights, quantities of make-good LNG that are being requested by the buyer to restore earlier quantity reductions, and other permitted operational adjustments) in order to arrive at the “adjusted annual contract quantity” or “AACQ”. Most importantly, the LNG SPA typically obliges the buyer to take-or-pay for, or pay for if not taken, the AACQ at the applicable contract price. Accordingly, if, in a contract year, the buyer fails to take a quantity of LNG at least equal to the AACQ (as measured at the end of that year), the buyer will become liable to pay for the product at (i) the applicable contract price (usually the average price during the applicable year) for such quantity; and (ii) the positive difference between the AACQ and the quantity actually taken and received by the buyer in such contract year (which is often defined as the “Quantity Deficiency”). Such payment made by the buyer is often termed as the “Take-or-pay Payment.”
Following the buyer’s making of any Take-or-pay Payment, the buyer usually becomes entitled to what is called a “make-up” right, namely, a right to take a quantity of LNG equal to the Quantity Deficiency (with such quantities being referred to as “make-up quantities”), either for no additional payment at all, or only in exchange for payment (either by buyer or seller, as the case may be) for the differential between (i) the contract price prevailing at the time of receiving the make-up quantities; and (ii) the contract price used to calculate the Take-or-pay Payment. However, it must be noted that the buyer’s make-up right usually is not absolute – it is often subject to certain conditions, such as the seller only being obliged to use reasonable endeavours to make available for delivery the make-up quantities, and/or that the buyer must take delivery of the make-up quantities within a certain number of years from the date such quantities first accrue. Also, as a matter of English and US law, there appears to be no general rule that a take-or-pay obligation must be accompanied by a make-up right in order to be legally enforceable; but it is currently the LNG industry practice for a buyer to have such make-up rights arising from a Take-or-pay Payment.
From the seller’s perspective, the key commercial reason for the take-or-pay structure in a long term LNG SPA is that the buyer bears the quantity or volume risk (sometimes also called the demand risk) by obliging the buyer to pay for a certain quantity of LNG each year, regardless of the actual demand on the buyer-side (which naturally may be difficult to predict accurately over a 15-20 year lifespan of a typical long-term LNG SPA). This provides the seller with the certainty of project revenue and a somewhat predictable cash-flow stream that is a minimum prerequisite for the type of multi-billion dollar project financings that are usually required by greenfield LNG export projects.
Hence, the take-or-pay obligation is often seen as a benefit (and indeed a necessity) for the LNG sellers who seek to develop and commercialize new projects. In exchange for bearing the demand risk posed by a take-or-pay obligation, the buyer is theoretically guaranteed a long term supply under an agreed price formula typically reflecting an agreed form of price indexation (which in Asia and some other markets is usually under a formula incorporating a Brent or Japanese Crude Cocktail (JCC) oil pricing index).
The Take-or-pay Obligation – What issues does this pose under the LNG SPA?
A fundamental consequence of the take-or-pay contract structure is that if a buyer fails to take any or all of the scheduled cargoes during a contract year the buyer is not in breach of contract, provided that the buyer timely pays the resulting Take-or-pay Payment. As mentioned earlier, the buyer’s obligation under a take-or-pay structure is in the alternative, i.e., it may either take delivery of (and pay for) the LNG in question, or it may instead choose to forego taking delivery and make the resulting Take-or-pay Payment. In fact, unless the SPA otherwise provides, the buyer can elect not to schedule any cargoes at all during a contract year and accrue a Take-or-pay Payment to be settled at year-end, and there would be no other contractual remedy for the seller in respect of such failure to take. Furthermore, upon settlement of the Take-or-pay Payment, the seller, in the ordinary course, would be obliged to provide make-up quantities in favor of the buyer during future contact years. It is precisely this possible outcome that the authors believe is typically not fully considered by sellers and project financiers when they opt for the traditional take-or-pay LNG contract structure.
(1) Seller’s Cashflow and Exposure to Buyer’s Credit Risks
If a buyer under a take-or-pay SPA does in fact exercise its right not take an entire year’s worth of cargoes, and opts to pay the resulting Take-or-pay Payment that becomes due shortly after the applicable year-end (an outcome that the authors concede is unlikely in most cases), the seller faces the prospect of only being paid once—after the end of the applicable year—rather than receiving regularly spaced payments over a contract year. This outcome could be very disruptive to the seller’s cash flow and its consequent ability to manage required debt service payments arising under its project financing arrangements.
Because the seller is exposed to the potential that the buyer may accrue a large take-or-pay liability before it is ever in breach of contract (since a breach would only occur at year-end and only if the buyer fails to pay the take-or-pay invoice), the seller may ultimately bear a significant unsecured non-payment risk absent sufficient and acceptable payment security to cover a year’s worth of scheduled LNG supplies. In practice, this risk is fairly common. It is customary for LNG sellers not to require payment security that covers a potential years’ worth of Take-or-Pay Payment exposure, especially for creditworthy companies that are proven long-term buyers (such as certain major Asian utility companies).
In today’s rapidly changing LNG trade, this risk has become amplified due to an increasing number of new buyers with relatively weak (or in some cases non-existent) credit and little LNG purchasing and payment record. This enhanced credit risk exposure resulting from the use of a traditional take-or-pay contract structure with certain LNG buyers may not be acceptable to a savvy seller or its project lenders. Unfortunately, simply increasing the required credit support to cover this risk is typically not a realistic option since this type of buyer will in many cases be unable to provide the enhanced payment security required in order to cover the seller’s full annual take-or-pay credit risk exposure.
To deal with the potential “snowballing” of the take-or-pay liability amount and the disruption this could pose to the seller’s cash flow and the accompanying increased requirements for payment security, one available option for a seller is to introduce into the SPA a right for the seller to terminate the contract if the buyer’s failure to take or schedule LNG reaches a certain level, or else provide that the take-or-pay quantity and performance regime will be calculated on a shorter period, e.g., on a quarterly basis. However, it must be noted that the seller’s termination threshold in a typical LNG SPA is usually fairly high (sometimes requiring the buyer to fail to take around 50% or more of the AACQ), and even a quarterly take-or-pay obligation may in some cases be fairly substantial. Hence, even these alternatives could still leave the seller with significant exposure to the buyer’s credit risk.
Furthermore, buyers may resist including such a termination right on the basis that the SPA is premised upon a take-or-pay basis, and as such the seller should therefore not have the right to terminate the agreement as long as the resulting take-or-pay invoices are being timely paid. Alternatively, the seller may try to introduce an escalator or ramp-up mechanism to payment security amount requiring the buyer to increase the value of the security once it fails to take or schedule a certain number of cargoes within a contract year. In the authors’ experience, most LNG SPAs do not contain such a payment security escalation mechanism, leaving the seller effectively unsecured for the difference between the buyer’s payment security amount and the buyer’s potential year-end Take-or-pay Payment obligation.
(2) Compensation for Loss Due to Failure to Take
Because the buyer’s obligation under a traditional take-or-pay SPA is to take a specified quantity of LNG on an annual basis, there is often no remedy to the seller under the SPA should the buyer fail to take one or more particular scheduled cargoes as long as by the end of the applicable contract year the buyer has managed to take the AACQ. In other words, there is typically no obligation on the buyer to compensate the seller for any costs or losses it incurs as a result of the buyer’s failure to take a scheduled cargo. In fact, under a traditional take-or-pay SPA, the seller could produce, load and transport a cargo to the buyer, and then the buyer could turn the cargo away at the receiving terminal and it would not be in breach of contract. Of course, such a turned-away cargo may ultimately trigger a year-end Take-or-Pay Payment, but at the time the cargo is turned away the buyer would be in full compliance with the SPA.
To add insult to injury, if the buyer later pays the resulting Take-or-Pay Payment for that turned away cargo, the buyer would then accrue a make-up right that is usually either free or is priced relative to the difference between the applicable market prices at the scheduled date of delivery and the actual make-up quantity delivery. In an LNG SPA where the seller is responsible for delivery and transportation to the buyer’s nominated receiving terminal, this arrangement does not cover the seller's lost transportation or vessel non-utilization costs, nor does it cover any receiving terminal or port charges that the seller had committed to before the buyer turned away the cargo. Because of this possible outcome, it is often a mistake for a seller or project lender to assume that the Take-or-Pay Payment will necessarily place the seller in the same position as it would been had the buyer scheduled and taken all of the cargoes comprising the AACQ.
(3) Practical Enforcement of the Take-or-pay Obligation
As mentioned earlier, the very essence of the take-or-pay structure means that it is not per se a breach or default by the buyer to fail to take all of the contractual quantities in a given contract year (as the buyer’s performance obligation is in the alternative, i.e., to take-or-pay, or to pay for if not taken). Following any such occurrence, the real question is whether many sellers would, as matter of commercial practicality, elect to issue a take-or-pay invoice for such a large amount knowing that it may render the buyer insolvent and thus potentially bring the contract to a premature end, as opposed to attempting to reschedule and restructure the buyer’s quantity obligation in order to avoid such an outcome.
In reality, the issuance of a take-or-pay invoice is such a rare occurrence that, while there are a few reported instances of take-or-pay invoices being sent in the international LNG industry, they typically tend to occur only in the most egregious circumstances; and a great number of people in the LNG industry have never seen such an invoice. This is due to a number of practical reasons.
First, there is an issue of whether the buyer would or could pay the take-or-pay invoice. Even calling on the available credit support would likely still leave the seller with receipts that are insufficient to cover the full amount of such invoice. Especially for a long term buyer, the failure to take cargoes (in particular multiple cargoes) may signal a more serious operational or financial issue; and in such an instance the issuance of a take-or-pay invoice may be of little benefit without very substantial credit support.
Second, a take-or-pay invoice is likely to have a detrimental impact on the long term commercial relationship with the buyer. This has historically been a particularly important consideration for many sellers (especially in the Asian market), as there have traditionally been only a limited number of buyers in the long term LNG market. For competitive reasons many sellers did not want to be seen as being unfriendly to long-term buyers. To date, the commercial reality in the LNG industry has been that if the buyer is unable to take multiple cargoes within a contract year, then the seller, assuming lender cooperation, will usually resort to some other form of commercial resolution to the problem (sometimes involving cargo diversions or rescheduling).
(4) Provision of Make-Up Quantities
English and US courts have so far not clearly required that the provision of make-up quantities is an absolute pre-requisite for the legal validity and enforceability of a take-or-pay obligation. That being said, it is the commercial and industry practice for make-up rights to be offered under a traditional take-or-pay LNG SPA. The question (and the related negotiation) often is in what form and under what conditions should such make-up rights be available.
Often, the make-up right is phrased in terms of the seller’s reasonable endeavours obligation to make available LNG in subsequent years, for instance, up to the end of the contractual term with a potential extension if there are outstanding make-up quantities not yet taken by such time. While a reasonable endeavours obligation is arguably not very onerous (i.e., under English law such an obligation generally does not require a seller to sacrifice its own commercial interests), it is still unclear what the seller is required to do in order to discharge such obligation. For instance, is the seller required to reserve liquefaction and/or shipping capacity for the supply of make-up quantities? Depending on how the make-up obligation is worded in the SPA, the obligation to provide make-up quantities could be a material constraint on the future marketing flexibility of the seller. On the other hand, if the make-up obligation is sufficiently weak, such an obligation may offer little comfort to the buyer that it will ever be able to recover its make-up quantities.
Furthermore, the provision of make-up quantities also leads to discussions with buyers regarding other questions that may be difficult to resolve. This includes whether the seller should refund to the buyer any Take-or-pay Payments if the corresponding make-up quantities are requested by the buyer but cannot be taken at the end of the term, and whether the result should be any different if this non-delivery of make-up quantities is due to the seller’s breach or the occurrence of force majeure. While most LNG SPAs do not provide for such refunds to be made, sellers are increasingly being requested to consider this outcome in settings where buyers have greater negotiating leverage to demand such a refund.
What Is the Alternative? Is It to Move to a Cargo-By-Cargo Regime?
We are now witnessing a growing trend of sellers and buyers considering other alternative forms to structure the buyer’s payment and delivery obligations apart from the traditional take-or-pay contract regime. This is due in part to the practical issues discussed above, as well as the need for so-called “portfolio sellers” (who are by definition not the original LNG producer, but are instead trading LNG cargoes from one or more supply sources) to be compensated for scheduled LNG cargoes on a more real-time basis, as well as the increased difficulty of such portfolio sellers to provide a buyer with any level of assurance whatsoever as to the seller’s ability to supply make-up quantities. The most commonly seen alternative is what is sometimes known as the cargo-by-cargo regime.
Under a cargo-by-cargo regime, the buyer’s failure to take is determined on an individual cargo-by-cargo basis, as opposed to an annual basis. Under the most commonly seen formulation, if the buyer notifies the seller that it will not be able to take delivery of a cargo by a designated timeframe or window, or if the buyer, having commenced taking delivery, is unable to complete receipt of such cargo by such time, then the buyer would be considered to have failed to take such cargo and the buyer’s obligation to compensate the seller for the resulting loss would accrue at such time (instead of only at year-end if the total quantity taken did not equal or exceed the AACQ). The seller would be entitled to resell the cargo that the buyer failed to take, and the seller would then be under an obligation to reimburse the buyer the net proceeds received from such resale (typically calculated as being the total proceeds received by the seller on the resale, less all incremental costs incurred by the seller as a result of thereof).4 This default and remedy structure has been successfully used for years in the case of spot LNG cargo sales. Thus, it is not unfamiliar to many in the LNG industry, save that it has not been as commonly used in the long-term LNG trade.
There are several benefits to this cargo-by-cargo approach from the seller’s perspective,. Most importantly, the buyer must settle-up after each missed cargo, including for transportation costs and any applicable port charges incurred by the seller. Because of this, there is much less likelihood of a later surprise for either party, and under such an arrangement the seller is also better positioned to manage its risks on a more real-time basis as and when the buyer’s failure to take a cargo arises. Of course, under either a take-or-pay or a cargo-by-cargo arrangement, the seller still must dispose of a distressed cargo or cargoes.
In this respect, a traditional take-or-pay contract arrangement does not make the situation easier from the buyer’s perspective; and it may actually worsen the situation for the seller since in a cargo-by-cargo arrangement at least the seller will see some cash-flow from the buyer sooner than it would in a year-end take-or-pay invoice setting. Because of the more immediate and prompt settlement of the buyer’s payment liabilities arising from its failure to take, the seller also has significantly less exposure to the buyer’s shorter-term credit risks. There is also no need to address the how firm are the parties’ rights and obligations surrounding the resulting make-up quantity and the related make-up timing questions (which is very compelling to parties involved in a transaction where the LNG is being supplier by a portfolio seller).
The cargo-by-cargo regime also addresses what is perhaps the biggest risk under a take-or-pay arrangement—the risk that payment security is less than a full years' take-or-pay obligation leaving the seller unsecured for the balance. In a cargo-by-cargo transaction, the seller can discontinue loadings or deliveries and terminate the contract either before, or at the time, it reaches the buyer's credit support limits. As a result, the payment security requirements may be less onerous for buyers, which would no longer need security to cover a year’s worth of cargo payments. Furthermore, additional and incremental costs due to the missed cargo are off set against the re-sold cargo value for the purposes of calculating the net proceeds. Recovery of these potential costs is not provided under the traditional take-or-pay contract regime. From the buyer’s perspective, it would lose the benefit of the apparent flexibility offered by the take-or-pay regime, but it would also not need to wait to take make-up quantities and face the risk of losing such quantities if it fails to schedule them by contract expiry.
The main complication arising out of a cargo-by-cargo contract arrangement in the LNG industry is that there appears to be little or no precedent for this type of contract arrangement (as opposed to a conventional take-or-pay arrangement) in a setting involving a project financed LNG liquefaction project. To date, the vast majority of cargo-by-cargo arrangements involve LNG sale contracts entered into by portfolio sellers and/or short to mid-term sellers which do not require the LNG SPA to underpin the financing of a greenfield LNG project. That being said, the authors are of the firm view that if the cargo-by-cargo SPA is correctly written, it could potentially work better than a conventional take-or-pay arrangement from a financing perspective, as there is potentially far greater regularity (and, in some cases, certainty) of cash flow, and there is also a better ability for the seller to manage its exposure to the buyer’s short and long-term credit risks.
Yesterday’s traditional LNG marketplace was built on a small number of LNG project owner-sellers and a marginally larger number of experienced and creditworthy buyers; and the commercial and contractual relationships were premised on long-term relationships and careful alignment of interests, all underpinned by the usage of the traditional take-or-pay contract regime.
Today’s LNG industry is populated by a large number of new and less experienced (and in many cases less creditworthy) buyers, as well as a new breed of portfolio sellers that do not have dedicated gas reserves and dedicated LNG production facilities available over the long-term. In this new LNG marketplace, the authors believe that it is worth considering whether the circumstances are now appropriate for a shift away from the traditional take-or-pay contract structure and toward a new cargo-by-cargo contract regime for long-term LNG SPAs. While there still may be compelling reasons under some circumstances for the use of the traditional contract structure, there increasingly appear to be circumstances where the cargo-by-cargo approach may provide a more tailored and efficient contract solution.