Unanticipated interruptions to gas supplies inevitably causes customers to suffer loss of some kind, and often tests the risk allocation mechanisms in gas sale agreements. This article examines 3 disputes arising from gas curtailments.

US decision: Ergon-West Virginia v. Dynegy Marketing & Trade

Hurricanes Katrina and Rita hit the US in 2005 damaging oil and gas infrastructure.

On 22 January 2013, the United States Court of Appeals for the Fifth Circuit (Fifth Circuit) held that natural gas clearing house Dynegy Marketing & Trade (Dynegy) did not have a contractual duty to refinery plants Ergon Refining and Ergon-West Virginia (Ergon WV) to attempt to secure replacement gas under its gas sale agreements (GSAs) after declaring force majeure in response to damage from the hurricanes.

Dynegy’s internally designated upstream suppliers of natural gas declared force majeure in response to damage incurred in the hurricane. Dynegy followed suit, declaring force majeure under its contracts with the Ergon refineries, forcing the refineries to buy replacement gas on the open market at increased costs. To recover these costs, the refineries sued Dynegy, alleging that the force majeure clauses in their GSAs required Dynegy to attempt to secure replacement gas, which Dynegy did not do.

The relevant clause in the Ergon Refining GSA required the party invoking force majeure to demonstrate that it had “remedied with all reasonable dispatch” the force majeure event. The court heard expert witness evidence which confirmed that it is gas industry practice for sellers to invoke force majeure if upstream suppliers have done so, and held that Dynegy’s response of delivering a portion of gas to Ergon Refining was sufficient to satisfy the “reasonable dispatch” requirement.

The force majeure clause in the Ergon WV GSA did not contain an “all reasonable dispatch” clause. Rather, it required that the party invoking the force majeure clause to demonstrate that the force majeure event was one that it was unable to prevent or overcome with “due diligence”. Although Dynegy agreed it could have found replacement gas on the open market, the Fifth Circuit held that the supplier had no duty to provide replacement gas to Ergon WV. Dynegy was not liable for damages from its failure to provide replacement gas.

The case is a reminder to drafters of GSAs to draft force majeure clauses which clearly articulate the obligations with respect to replacement supplies. In particular, attention should be given to the treatment of:

  1. whether supply is designated from a certain source,
  2. what replacement obligations arise and when, and
  3. the price implications (consistent price, price cap or full pass through).  

Disputes lawyers may be interested in the court’s preparedness to rely on expert evidence of standard industry practice, both to inform the factual question of what was “reasonable dispatch” and to inform the proper construction to be given to ambiguous terms.

Alcoa of Australia Ltd v Apache Energy Ltd [2012] WASC 209

Alcoa, the owner and operator of alumina refineries in WA, is seeking damages as a consequence of Apache, Tap and Kufpec (the Licensees) failing to deliver gas under their GSA with Alcoa following the Varanus Island explosion in June 2008.

The Varanus Island oil and gas processing facilities which processed the gas supplied under the Alcoa GSA were damaged following an explosion in a sales pipeline. Apache Energy was the operator under the applicable pipeline licenses, controlled the day-to-day operation, management and maintenance of the Varanus Island facilities and was the administrator of the GSA under operational agreements with the Licensees.

Alcoa alleges that:

  • Apache Energy and the Licensees failed to prevent corrosion on the gas pipeline that ruptured due to insufficient maintenance or repair; and
  • the Licensees’ inability to supply gas under their GSA could not be declared a force majeure event as the incident was either within the control of the Licensees or could have been prevented or overcome through the exercise of care expected of a reasonable and prudent operator.

Alcoa claims damages for:

  • economic loss for breach of duties of care owed by Apache Energy (as operator) and the Licensees;
  • breach of statutory duties; and
  • under contract, including the cost of purchasing alternative gas and the cost of purchasing diesel due to the unavailability of gas.

On 20 June 2012, Justice Le Miere of the WA Supreme Court delivered judgment on an application by Apache Energy and the Licensees to strike out or summarily dismiss various of Alcoa’s claims.

His Honour held that Alcoa’s claims for damages for breach of a statutory duty could not succeed and should be struck out.

Alcoa originally claimed that clauses in the GSA limiting the Licensees liability for delivery failures to the payment of liquidated damages were void and unenforceable as a penalty. This was not pursued and it too was struck out.

Justice Le Miere held that the question of whether Apache Energy and the Licensees owed Alcoa a duty of care, and the issues of control, assumption of responsibility and vulnerability, should be determined in light of the facts established at trial. The Licensees have appealed this element of the judgment, and it is scheduled to be heard next month.

If this claim advances to judgment, it ought provide clarification of the effectiveness of a fairly standard force majeure clause, where the operator’s maintenance practices are alleged to have caused the outage. It will also further clarify the relationship between express contractual risk allocation mechanisms and an overarching duty of care.

The full judgment is available here.

The meaning of ‘reasonable endeavours’: recent guidance from the WA Court of Appeal

The Western Australian Court of Appeal recently overturned a Supreme Court decision on the meaning of ‘reasonable endeavours’ within a major gas supply agreement.

The judgment on appeal reinforces cases that:

  • all reasonable endeavours clauses must be interpreted within the context of the parties’ broader agreement, but
  • a party required to exercise reasonable endeavours is unlikely to have a complete discretion as to whether to perform the relevant obligations.

Background

Electricity Generation Corporation t/as Verve Energy v Woodside Energy Ltd [2013] WASCA 36 also arose in the context of the sudden drop in gas supply to the Western Australian market following the 2008 explosion at the Varanus Island gas processing plant.

Verve Energy (Verve) was the purchaser under a long-term gas supply agreement (GSA) with participants in the North West Shelf Joint Venture (the Sellers). Under the GSA:

  • the Sellers were obliged to provide a mandatory minimum daily quantity of gas;
  • if Verve indicated that it required additional gas, the Sellers were required to use “reasonable endeavours” to make the additional gas available on a firm basis; and
  • the Sellers’ obligation was qualified, including that “In determining whether they are able to supply [additional gas] on a Day, the Sellers may take into account all relevant commercial, economic and operational matters …”.

Verve separately purchased gas from Apache, which was processed at Varanus Island, but that supply source was curtailed as a result of the explosion.

The reduction in supply meant that the Sellers were faced with more demand than they were able to meet, and purchasers offering prices above those stipulated in the GSA.

The dispute

The Sellers informed Verve that the disruptions to Apache’s supply meant that the Sellers could not supply Verve the additional gas it had requested under the GSA. The Sellers instead offered to supply an equivalent volume of gas under a new agreement under which Verve was required to pay a higher price for an interruptible supply. Verve entered the new agreement under protest.

The central dispute in the case was whether this breached the Sellers’ obligation to use reasonable endeavours to supply additional gas requested under the GSA. Verve alleged that the Sellers were obliged to provide additional gas if such gas existed; the Suppliers argued, in essence, that the constrained supply situation and market demand at higher prices were commercial factors which they were properly entitled to take into account in deciding whether or not they were able to supply additional gas.

The Supreme Court decision: Sellers entitled to follow their commercial interests

The Sellers were successful in the Supreme Court. The judge considered that:

  • the GSA did not prevent the Sellers from entering into third-party contracts that would limit the Sellers’ ability to meet Verve’s requests for additional gas; and
  • the words “able to supply” had to be read in light of the Sellers’ entitlement to take into account “all relevant commercial, economic and operational matters”, which would include the relative profitability of the price offered by other customers.

The outcome on appeal

The Court of Appeal overturned the Supreme Court decision.

It held that, although the Sellers were entitled to take into account commercial, economic and operational matters in reference to their ability to supply gas, this did not give them an ‘option’ not to sell additional gas to Verve under the GSA because they could sell that gas to others at a higher price on an interruptible basis.

The key elements of the Court’s reasoning were:

  • the fact that the requirement to use reasonable endeavours was expressed in the language of obligation, ie ‘able’ to supply, rather than ‘willing’ to supply; and
  • the importance of that obligation within the scheme of the GSA, particularly the reliance that Verve placed on a firm supply of additional gas where it could be made available and the fact that the GSA expressly provided for the liability of the Sellers where they failed to use reasonable endeavours.

As if to highlight the commercial uncertainty generated by the decision and the complexity of the task confronting Sellers at the time, Murphy JA commented that the Sellers would have been justified under the GSA in refusing to provide additional gas to Verve, on the basis that market conditions effectively required the Sellers to sell gas to parties who were prepared to offer substantially more than the GSA price. However, because the Sellers decided to sell gas to Verve, he held that they were ‘able’ to meet their obligation to exercise reasonable endeavours to sell the gas under the GSA. Accordingly, once the Sellers elected to enter into a new agreement with Verve (which Verve no doubt considered preferable to receiving no additional gas at all), the Sellers were in breach of the GSA.

Take-home points

  • Reasonable endeavours clauses will always be read in light of the contract as a whole.
  • Even in contracts where the party obliged to exercise reasonable endeavours is entitled to take account of its own interests, the courts are unlikely to find that that party has a complete discretion as to performance unless this is made very clear.
  • Difficult commercial judgments must be made as to the proper construction of risk allocation provisions under time pressure. The more prescriptive the language, the clearer will be the commercial decisions. In this case, even different judges with the benefit of hindsight and the luxury of thoughtful deliberation have reached different views as to the proper operation of the provision.The Court of Appeal overturned the Supreme Court decision.

The full judgment is available here.