The Rise of Domestic Gas Obligations

The increase of domestic gas ("domgas") obligations imposed by Host States in pipeline gas or LNG export projects has become a trend in the international gas industry. [1]

A "domgas" obligation is a mandate established by contract or regulation by a Host State over a hydrocarbons producer/exporter so as to allocate a portion of its natural gas reserves and production to the domestic market, on a permanent or temporary basis, in exchange for a consideration or as part of the Government-take. [2]

In a world where gas exporting countries are increasing their domestic consumption at astonishing rates (e.g., Egypt, Russia, even Qatar), "domgas" schemes are gathering momentum. Despite a worldwide surge in gas production during the last decades, some States have not been able to simultaneously meet their overseas gas commitments and their fast-growing domestic demand for gas, forcing the curtailment of pipeline exports and the progressive slowdown in LNG exports as the domestic sector is prioritized. [3]

Ideally, States should consider the terms and conditions of E&P contracts executed or approved before any "domgas" obligation is established. If the producer/exporter holds a right to freely export gas or LNG, States should consider grandfathering such E&P contracts, or if not, accept the risk of being exposed to legal claims brought by such investors. However, the reality is that Host States respond to economic and political pressure, which generally prevail over respecting existing investors' rights. [4]

In this context, in addition to structuring an investment under the protection of a Bilateral Investment Treaty (BIT), a precise allocation of the "regulatory risk" within the gas export agreement or LNG sales and purchase agreement (SPA) is fundamental and may be achieved, for example, by using a "regulatory force majeure" clause.

The "Deliver-or-Pay Wars" of the Southern Cone

During the 1980s, the U.S. experienced the so-called "take-or-pay" wars between natural gas producers (acting as "sellers") and pipeline companies (acting as "buyers"), triggered by a combination of natural gas surplus and falling natural gas prices in the U.S. domestic market and "take-or-pay" clauses in gas sales agreements. [5]

Recently, during the mid-2000s onwards, the Southern Cone went through "deliver-or-pay wars" between Argentine natural gas exporters and their Brazilian, Chilean and Uruguayan customers (mainly power generators and gas distribution companies), due to a combination of gas shortage in the Argentine domestic market and "deliver-or-pay" clauses in gas export agreements. [6]

Take-or-pay and deliver-or-pay clauses follow the same pattern. They specify a monthly or annual minimum quantity of gas that the buyer or seller has to take or deliver, respectively, and if not, pay for it. Such clauses are well-known in project financing of "gas-to-power" and LNG export projects, because they protect parties from "volume risk" and are key to securing an "income stream". [7]

The Heart of the Dispute

To be discharged from their "deliver-or-pay" commitments, Argentine natural gas producers that during the mid-1990s had entered into long-term (15-20 years) gas export agreements with Brazilian, Chilean and Uruguayan importers, invoked the "force majeure" clause of their relevant agreements. In a nutshell, they alleged that the Government of Argentina had drastically changed the legal framework applicable to gas exports by imposing a "domgas" obligation and curtailing exports until the domestic market was fully supplied.

Importers rejected the "regulatory force majeure" arguing inter alia that the export curtailments were (i) not unforeseeable (as the Government of Argentina always had the right to establish a "domgas" scheme), (ii) not external (as the gas shortage in Argentina was due to the producers' lack of investment in E&P), and (iii) not impossible (as the producers could still export if they implemented energy swaps at their cost). [8]

Lessons Learned

The outcomes of these disputes have been diverse. Producers have prevailed in some, importers in others, some have been settled, and some are still in arbitration. But ultimately, in one way or another, the "force majeure" clause drafted in those gas export agreements was not as effective as it should have been.

When negotiating the "force majeure" clause in a gas export agreement or LNG SPA, producers may consider the following guidelines based on the experience gained during the "deliver-or-pay wars" of the Southern Cone:

  • Include a broad "regulatory force majeure" clause that specifically captures all types of Governmental restrictions affecting the free marketing of gas. This includes oral, de facto, and informal orders. Indeed, the Government of Argentina used to implement the export curtailments through telephone calls to the dispatch operators or transportation companies ordering them to re-route export volumes to the domestic market, without issuing any formal restriction or regulation.
  • Include both total and partial restrictions (not only prohibitions). The Government of Argentina did not prohibit gas exports but the condition precedent for exporting was to maintain the domestic market fully supplied. In practice, this obligation worked like a prohibition as one producer cannot guarantee the supply of an entire domestic market.
  • Use broad language when defining "Authority" or "Government". Such drafting should aim to capture situations where the regulation is not necessarily implemented by the enforcement authority, but rather by de-facto or ad-hocGovernment officials, or even third-party private companies (gas transporters) by mandate of the Government.
  • Include a "Representation" on the main legal assumption relied upon by the parties, such as the "firm" (non-interruptible) nature of the gas export permit issued by the Host State. By way of example, a representation like this would have been helpful for the producer in the "deliver-or-pay wars" of the Southern Cone: "The Parties acknowledge that pursuant to the applicable legal framework the Seller holds a valid export license that grants the right to export xx M3/day of natural gas on a firm basis; that this right is essential to ensure the performance of seller's obligations; and that it is unaffected by any supervening gas shortages in the domestic market".
  • When facing a "force majeure" event, be clear to state whether the seller has (or does not have) the obligation to provide substitute gas or alternative fuels (e.g., diesel oil, fuel oil, LNG, etc.) and which party bears any resulting incremental costs.
  • Establish which mechanisms are triggered when a "force majeure" event occurs. Additionally to the suspension of the obligation while the event occurs, will the parties have the right to terminate the agreement upon certain conditions?
  • Be clear if the obligation (if any) to negotiate in good faith a mutual satisfactory solution entails undertaking additional costs or a "shared sacrifice".
  • If the seller makes a representation regarding the existence of sufficient gas reserves, be sure to specifically qualify certified volumes by reference to current economic and regulatory conditions in the Host State.

The Southern Cone will eventually embark on a second generation of gas export projects, as vast quantities of shale gas have been discovered in the region. Other regions (including Canada and the U.S.) are also embarking in new gas export projects. As a well-known Spanish philosopher said: "Those who cannot remember the past are condemned to repeat it".[9] Come what may, let us learn from the "deliver-or-pay wars" of the Southern Cone.