High Court decisions in the UK and Australia have cast doubt on the enforceability of take-or-pay contracts. This could be a big deal in Australia’s coal sector where many miners and their customers are locked into long term contracts and are losing money hand over fist.

During Australia’s mining boom, long term take-or-pay arrangements1 underpinned many energy and resources projects. For miners, the contracts guaranteed them minimum streams of revenue and protected them from any downward price fluctuations.

Project financiers frequently required miners to enter take-or-pay agreements with customers to provide certainty as to servicing of the debt they provided.

Take-or-pay contracts also featured heavily in the development of mining-related infrastructure such as railways and ports, and the supply of mining equipment and critical supplies like explosives. Similar to agreements between miners and customers, these take-or-pay arrangements guaranteed infrastructure and equipment suppliers minimum demand levels (for rail or port facilities or equipment) over long periods.

After the boom losses mount under take-or-pay arrangements

Demand for Australian coal has been greatly impacted as Chinese and Indian growth have slowed and exports of cheap coal from the US has surged (a result of the shale gas revolution in the US with shale gas becoming a real alternative to coal in the US domestic market). 

Plummeting coal prices have left miners and their customers exposed to obligations to take or pay for products and commitments they may not need.  

Some Australian miners are producing coal at costs higher than the market price. Others are being forced to declare contingent liabilities on their balance sheets where they have obligations to pay for committed but unused port and rail capacities.  Under those contracts the coal miners have to pay the rail or port operators the agreed minimum amount for rail or port access even if they require less (or no access).  

Take-or-pay contracts are adding an estimated average of $15 per tonne to the coal industry’s production costs. 

In theory coal miners could cut production in an effort to drive up prices by causing a shortage.  However, take-or-pay arrangements mean that cutting production would not significantly reduce costs, as coal miners are contractually obliged to pay irrespective of their production level.

A recent report by Wood Mackenzie2 confirms that take-or-pay contracts are leading miners to continue production, despite the losses. In fact, coal production in 2013 is likely to be at nearly the same levels as the previous year. In total, around 32,000,000 tonnes of coal is expected to be produced at a loss this year.

To make matters worse, a number of customers under take-or-pay coal supply contracts are purchasing the minimum contract amounts of coal and disposing of their surplus needs on the spot market.  This is putting further pressure on the market price of coal.

Enforceability of take-or-pay arrangements

However, two recent decisions, one by the UK High Court in E-Nik Ltd v Department for Communities and Local Government [2012] EWHC 3027 (Comm) and one by the Australian High Court in Andrews v ANZ (2012) 290 ALR 595, raise issues around the enforceability of take-or-pay contracts3. In short, take-or-pay clauses may in certain cases constitute penalties and therefore be unenforceable. The question whether a take-or-pay provision is a penalty is one of characterisation, to be determined as a matter of substance, taking into account all the circumstances4.

The implications of Andrews have been well canvassed, including in two articles by Corrs Chambers Westgarth: Andrews v ANZ - Do all contracts need to be rethought? and What do productivity, performance contracts and a bank fee dispute have in common?.

As take-or-pay obligations continue to cause difficulty in the coal mining sector and more broadly, Australian companies subject to these obligations may follow the lead of their British counterparts (such as in E-Nik) and seek to challenge their enforceability.

Such challenges could have significant implications not only for the parties to the take-or-pay contracts concerned, but also their financiers.  In the current economic climate, there is potential for parties to litigate these types of contracts as was seen in the similar  downturns that affected the international oil and gas markets in the early 80s.

The particular take-or-pay provision in each individual contract will need to be judged in the context of the particular circumstances surrounding it.  However, as a general proposition, the take-or-pay provisions typically found in port and rail contracts in the Australian coal sector are commercially negotiated and justifiable arrangements, and seem likely to withstand challenge and be found to be valid and enforceable.

Purchasers may also be considering approaching their suppliers to renegotiate take-or-pay arrangements.  That may serve both parties’ interests.  However, purchasers need to be careful how they approach suppliers in such negotiations so as to avoid any potential claims of anticipatory breach of contract.