World gas markets have recently been marked by a period of considerable volatility, both in terms of demand and prices.
In the Atlantic basin in particular, demand for LNG has decreased following the global economic downturn and as a result of the growth of US domestic shale gas supplies. Conversely, increased demand for LNG has recently been seen in Asian markets, as a result of the Japanese earthquake and tsunami of March 2011. Prices under traditional long-term gas and LNG contracts have recently been placed under considerable pressure. Reasons for this are various but include increased supply from new sources of gas production coming on stream, the impact of shale gas and the growing importance of the spot LNG market globally, as well as an increase in gas-to-gas competition. This has particularly been the case where prices under such contracts are linked to oil, because both oil demand and oil prices have been supported in the international market.
Because margins for their on-sale arrangements have become lower or, in some cases non-existent, many buyers are seeking to renegotiate their long term gas and LNG contracts in order to reduce prices, to replace oil indexation provisions and to introduce more flexibility into their take or pay obligations (for example by negotiating volume flexibility or increased diversion rights).
One method through which buyers have sought to change the pricing under their long-term contracts is to trigger price reviews under those contracts. Price review provisions typically provide for disputes to be resolved by arbitration. Due to the confidentiality of arbitral processes, it is difficult to gauge the number of price reviews which have resulted in arbitration. However, the evidence points to an increasing number being submitted to arbitrators for determination.
Drafting price review clauses
Whilst in Asian markets detailed price review clauses have traditionally been quite unusual, complex price review clauses are traditionally found in European long term gas and LNG contracts. These are often badly drafted and it is worth taking the time to get these right. They are often structured as follows:
- initial trigger event for price review
- delivery of a review notice
- agreed criteria to be applied for the review
- period of negotiation
- determination by arbitral tribunal (in accordance with the agreed criteria for the review)
Drafting each of these phases carefully is key. For example, careful consideration should be given to the definition of the reference market for agreed criteria, the overlap between the trigger event and the agreed criteria should be considered, and thought should be given to the timing and procedure for a review.
Price review arbitration
As set out above, price review provisions in long term LNG contracts typically provide for a period in which negotiations may take place, before either party can initiate arbitration proceedings. Wherever possible, parties will generally consider it preferable to resolve any dispute regarding prices through negotiation rather than arbitration, in order to avoid the inherent risks involved in an adversarial dispute resolution process, and the negative effects which a drawn-out dispute may have on a long term contractual relationship. However, if a settlement cannot be agreed upon, and a dispute is submitted to arbitrators for determination, then in many cases it may be possible not only to limit some of the risks involved in such a process, but to use price reviews as an opportunity to control some of the wider risks in the current LNG market environment.
In order to mitigate the risks associated with price review arbitrations it is, of course, important to select a tribunal with the right technical and commercial outlook. It is also possible to take steps to restrict the parameters of a price review arbitration, in order to reduce the risk of a tribunal either imposing their own revised price formula, or adopting a revised formula which, while striking some sort of compromise between the parties, may make little economic or commercial sense in itself.
In certain circumstances it may also be possible to split the arbitration process, so that an initial hearing is held solely to determine whether or not the trigger event has occurred (and therefore whether there is any basis for revising the price formula), with a further hearing being held, if necessary, in order to determine exactly how the price formula should be revised.
Price review discussions and disputes are increasingly becoming part of the commercial landscape for long term LNG contracts and parties should be more prepared for disputes as current market volatility continues. It is therefore more important than ever that price review provisions are properly drafted. In the event of a dispute, by adopting a more structured arbitration process, it may be possible to manage, to an extent, the uncertainty which has formerly been perceived in contesting these disputes.