Each year 40 billion litres of petrol are sold into the retail and industrial markets of Australia. Petroleum distributors – sandwiched between powerful suppliers and extremely competitive customers – operate in a challenging business environment. Like commodity trading businesses, profits depend on achieving ever higher volumes on ever thinner margins. But distributors don’t just play the margin – they have a physical responsibility that extends from supplier to retailers and end users. They face a whole host of safety, social, environmental, and statutory reporting requirements. Costs need to be carefully managed, customer relationships need to caringly maintained, and contracts need to be cleverly negotiated.
Pricing is critical. Petroleum distributors look for discounts on terminal gate prices offered by the major petroleum sellers, and are willing to commit to long term supply arrangements to secure those prices. “Take or pay” obligations – commitments to take a minimum volume and to pay for it even if it isn’t taken – are demanded by sellers. Often, the seller will also demand the ability to change future prices.
Recent Australian court decisions have cast doubt over the enforceability of these important take or pay obligations and pricing mechanisms. And, quite apart from formal legality, it is important to have a commercial and practical approach towards contractual obligations and safeguards.
In this Focus on Energy and Resources, Christopher Hewitt and Emilie Franklin take a closer look at take or pay obligations and pricing discretions, and at how petroleum distributors can best protect themselves from the risks associated with these contractual mechanisms.
Wholesale petroleum supply agreements – same but different
Petroleum distribution margins are tight, and securing low prices from sellers is essential for improving those margins. Certainty, or at least some comfort, in relation to price fluctuations is just as important. A wholesale supply agreement can provide a purchaser with greater certainty and more predictable margins. However, a poorly drafted wholesale supply agreement can trap a purchaser in an uncommercial arrangement that may threaten its commercial survival.
A “standard” wholesale supply agreement will usually include:
- a discounted price worked back from a standard Terminal Gate Price;
- a take or pay obligation – the provision that locks in payment for a minimum off-take;
- a price variation discretion for the seller – argued to be essential by the seller, but significantly undermining certainty for the purchaser.
But each wholesale supply agreement will also have its own “unique” features. The major sellers borrow from each other’s standard agreements, and will often seek to improve their position even more by subtle wording changes that can have major impacts. Every term of a supply agreement must be carefully reviewed so as to understand the deal that is “on the table”, to find ways to improve the deal, and to minimise the risks.
Take the fuel or pay the price
Take and pay obligations in the downstream petroleum industry require a seller to make available a minimum volume of the petroleum product concerned to the purchaser over a certain period of time. Likewise, the purchaser is obliged to “take” that minimum quantity from the supplier in that period. The petroleum supplied within the minimum quantity is characteristically sold at a price below market value to induce the purchaser to enter the supply agreement. This price may be the seller’s usual Contract Terminal Gate Price and may include further discounts and incentives.
This all sounds quite straightforward. However things get more complicated if the purchaser fails to “take” the minimum quantity. Generally, if a party fails to perform a contractual obligation the failure will constitute a breach of the contract, allowing the other party to either enforce the contract or terminate it and seek damages. However, the drafting of some take or pay provisions does not render a failure to “take” the required amount as a breach. Instead, such a provision will simply oblige a purchaser to pay a pre-agreed amount to the seller if the purchaser fails to purchase the minimum quantity.
Colloquially, this is often described as “take all the fuel, or pay for it anyway”. In practice, the amount that the purchaser must pay to the seller is often less than the amount the purchaser would pay if they took the minimum quantity. The reason for this is that even though the seller will lose out if the minimum quantity is not purchased, the seller will still be able to sell that un-purchased petroleum to a third party. The supply agreement will often include a methodology that calculates a per litre amount that the purchaser must pay for each litre of petroleum the purchaser failed to purchase.
The risk of take or pay provisions is obvious. The purchaser agrees to purchase a minimum quantity in the expectation of certain on-sales. If those on-sales do not materialise, or a regular customer is lost, then the purchaser may be left with petroleum that it cannot on-sell or must sell at a loss. Worse still, a purchaser might even be in the position of paying for petroleum without even acquiring it. These kinds of long term “minimum quantity” commitments can become a nightmare for an over-confident purchaser. In the coal industry, when demand and prices dropped, take or pay obligations for port usage crippled many coal exporters.
Fairness and flexibility in take or pay provisions
Although the risk of a take or pay clause can never be fully eliminated, they certainly can be softened so as to promote profit and reduce risk. For example:
- a tolerance allowance can be included, whereby the obligation to pay only arises if less than an agreed percentage of the minimum quantity is purchased;
- minimum quantities can be set on an annual basis, rather than monthly or quarterly, allowing slower periods to be balanced against busier periods, and giving a purchaser the opportunity to recover from the temporary effects of unforeseen circumstances; and
- an annual “escape” clause can be afforded to a savvy purchaser, allowing termination in the case of a substantial change in commercial circumstances, such as the loss of a primary customer.
Negotiating amendments to a take or pay obligation requires commercial acumen, industry knowledge, and a willingness on the part of both parties to negotiate reasonably.
Take or pay clauses may be unenforceable
Parties to a contract are allowed to agree that a particular contractual breach will require the defaulting party to pay a pre-agreed amount of compensation. The law allows such compensation to put the injured party back in the position it would have been had there been no breach of contract, but not more. In other words, agreed “compensation” should not be punitive against the defaulting party. If the amount of money that must be paid by a defaulting party is not a genuine pre-estimate of the loss that will be suffered by the other party, the clause will be deemed a “penalty” and will not be enforced by the courts.
Lawyers have attempted to avoid problems with the doctrine against penalties by drafting clauses that do not suggest that the event triggering the pre-agreed compensation is a breach of contract. Take or pay provisions can be examples of this approach – in that non-achievement of a minimum quantity off-take is not said to be a breach of contract, but still requires a payment in lieu of that achievement. However, in Andrews v Australia and New Zealand Banking Group Ltd, the High Court ruled that a contractual provision may constitute a penalty even if it does not relate to a breach of contract. The obligation in that case related to bank over limit fees which the High Court found had the primary purpose of securing contractual performance. The question of whether or not that payment was a genuine pre-estimate of loss was remitted back to the Federal Court for decision.
Accordingly, even if a contract states that the fee or payment is not related to breach, a court will consider whether the fee or payment is used to force a party to comply with the contract and strike it down if it is not merely compensatory. Obviously, the amount that must be paid by a purchaser under a take or pay obligation will be critically important in this regard. If the amount is excessive when compared to the amount of loss suffered by the seller, then a court may find that it is a penalty. And if the payment is a penalty, a court will find it to be invalid and unenforceable.
Petroleum purchasers should keep this in mind when negotiating off-take supply arrangements. Purchasers already bound by such clauses should seek legal advice before “paying” for petrol they haven’t actually purchased. Generally, courts do not look kindly on parties that try to get out of their obligations because it suits them – however courts will look carefully at all the circumstances and grant relief where justified.
The balance between price certainty and price flexibility
It is increasingly common for wholesale supply agreements to include a provision that states – regardless of the fact that the parties have agreed on a Contract Terminal Gate Price – that the seller may change the price or price methodology at its discretion. Such provisions undermine certainty for the purchaser, and create significant commercial risk.
High volume off-take agreements justify locked-in prices. Where a seller has price discretion, the purchaser faces an ever-present risk that its hard-won profit margins may be lost. This problem will be compounded if the supply agreement includes a take or pay provision. If the seller uses its discretion to change the price, the purchaser may be forced to purchase (or pay for) “unwanted” petroleum at uncommercial rates for an extended period.
A purchaser should always check whether a supply agreement includes seller price discretion, and consider the risks of agreeing to such an arrangement. Alternative provisions and moderating mechanisms can be proposed to the seller, so as to minimise the risk to the purchaser. Sellers should not be averse to these kinds of proposals, because a workable contract is far more preferable than a broken one.
Find the middle ground in your negotiations
Wholesale supply agreements are fundamental to the business of petroleum distribution. If they are negotiated and prepared correctly they can cement a properly collaborative and mutually profitable relationship between seller and purchaser. Some purchasers have entered into wholesale supply agreements that pose considerable commercial and legal risk. But no purchaser should consider this to be the inevitable result of having to deal with large and powerful seller organisations. A purchaser has every right to question the terms of any supply agreement proffered to it, and should look for commercially-focused legal solutions during negotiations to minimise the risks. Remember – there is a middle ground in a supply agreement that can work for both parties.