Notes From The Field - An English Law Perspective On The Oil & Gas Market

Natural gas is composed primarily of methane, with varying elements of ethane, propane, butane and the progressively heavier hydrocarbons. Small quantities of nitrogen, oxygen, carbon dioxide, sulphur compounds and water may also be found. Transforming natural gas into LNG is a complicated process. Its fundamental aim is to create a product that is non-corrosive and non-toxic, inhibits the formation of liquids within transportation infrastructure and satisfies the expectations of end users in relation to quality specifications. In simple terms natural gas that comes to the liquefaction plant from a production source is treated to remove impurities before being cooled to a temperature of -161°C. Traders and transporters of LNG have an interest in compliance with defined quality specifications. An LNG ship owner is principally concerned with ensuring that its LNG ship is not damaged by impurities, thereby causing a suspension of operations and loss of charter hire payments. A seller of LNG, responsible for the delivery of LNG of a defined quality specification, will be concerned to avoid liability under its sales contracts.

LNG industry participants pride themselves on their involvement in the production, sale and transportation of an inherently clean commodity. Anyone who has had the pleasure of negotiating liabilities for the provision of off-specification LNG under an LNG sale and purchase agreement will be very familiar with the popular refrain that ‘it never happens’. However, a recent case in the English courts has called this article of faith into question.

Debris in LNG ships

The English High Court recently dealt with the issue of LNG cargoes containing debris in American Overseas Marine Corp v Golar Commodities Ltd (“The LNG Gemini”) ([2014] EWHC 1347). Golar loaded a cargo of LNG at the Cameron terminal in Louisana on The LNG Gemini, a ship chartered by Golar from American Overseas Marine Corp (“AOM”). AOM later discovered debris in the ship’s tanks (several months and cargo operations after the particular Golar cargo had been loaded, shipped and unloaded) and claimed damages from Golar for the cost of major repairs to The LNG Gemini and for lost hire payments whilst the ship was laid up for repair.

Golar denied liability, but accepted that when the ship was loaded at the Cameron terminal then, on two separate occasions, some small particles (approximately a third of which were metallic) had passed through the mesh filters in the manifolds before they became clogged.

The charterparty (which was based on the widely used ShellLNGTime 1 proforma charterparty contract) provided that:

No acids, explosives or cargoes injurious to the Vessel shall be shipped and without prejudice to the foregoing any damage to the Vessel caused by the shipment of any such cargo, and the time taken to repair such damage, shall be for Charterers account.

AOM claimed that the ship’s cargo tanks/pumps were found to be “contaminated with metallic particles” that had been introduced by the cargo loaded in Louisiana, thereby causing “abrasion, rust and risk of electrical short and pump failure”. AOM argued that:

  1. proof of physical damage was not necessary (since the ship was an instrument of trade and any interference with the ship’s use for trade would therefore be injurious to it – and a cargo could be injurious if after delivery the ship needed to be cleaned and taken out of service to undertake cleaning); and
  2. a propensity to cause physical damage was sufficient. Metallic particles in the cargo created a risk that the ship might be damaged if the particles got trapped in motors or bearings, or they found their way into junction boxes on the cargo pumps, or they affected the sensors that monitored cargo levels in the tanks.

The court was not prepared to accept the first argument. The charterparty clause dealt with "repairs" of damage caused by cargoes that were "injurious to the vessel" and caused physical damage. There was express reference to two types of cargo which might cause physical damage to the ship, namely acid and explosives, but the clause also covered other cargoes that might cause physical damage.

The second argument found more favour. The evidence, however, did not establish that larger particles were loaded to any significant degree. The court referred to guidelines issued by the Society of International Gas Tanker and Terminal Operators (“SIGTTO”) which provided for LNG cargoes to be loaded through filters of a certain size at the ship’s manifold. The manifolds in The LNG Gemini were unusually fine and in compliance with the guidelines. The evidence also did not provide a basis for inferring how much debris in the cargo tanks was loaded by Golar.

The court was therefore not persuaded that Golar had shipped a cargo which was injurious to the ship, nor that particles in the cargo had created a potential danger of physical damage.

Quality specification in an LNG SPA

Other than the limitation on the charterer to not load any injurious cargoes that cause or have the propensity to cause physical damage to the ship, charterparties do not include any prescriptive provisions in relation to the specifications of LNG cargoes that the charterer loads onto the ship. In stark contrast, the quality specification of LNG to be delivered under an LNG SPA is a matter of some negotiation and will be stipulated in detail in the technical schedules to the SPA. This is because in addition to potentially causing damage to the LNG/regas reception and ultimate consumption facilities, off-specification LNG cargoes may not be usable by the end user.

The typical components addressed in a quality specification provision include:

  1. the minimum methane content;
  2. the calorific value of the LNG, which usually appears as a range with a minimum and a maximum permissible level;
  3. the maximum permissible levels for impurities (e.g. for carbon dioxide, sulphur compounds, oxygen and water);
  4. the minimum and maximum delivery temperature for the LNG;
  5. the Wobbe Index, which is an expression of the calorific value of a gas flame at the point of combustion and is relevant to ensuring that gas when combusted will be compatible with the equipment within which that gas is combusted (e.g. a burner tip) through stability of the resultant flame;
  6. the relative density, i.e. the ratio of the average molecular weight of gas to that of air; and
  7. the lack of objectionable materials, i.e. the LNG should be free from certain forms of commercially objectionable materials. LNG debris of the kind discussed in the Golar case would fall under the category of objectionable materials.

Generally, the seller will want to keep the quality specifications wide in order to minimise the frequency of off-specification events and to maximise the quanitity of delivered cargoes for which it receives the full purchase price. On the other hand, the buyer will want to narrow down the specifications to fit the requirements of the end user. For example, the specifications of gas required as feedstock for a power station will be very different from that required as feedstock for a petrochemical production facility.

The quality of each LNG cargo is determined by reference to the LNG as it is loaded into the buyer’s LNG ship at the loading port (where LNG is sold under an FOB-based SPA) or by reference to the LNG as it is unloaded from the seller’s LNG ship at the unloading port (where LNG is sold under a DES-based SPA). Accurate measurement of the quality specifications is key and of vital importance in an LNG SPA (unlike under a charterparty) since price is linked to delivery of LNG of a particular specification.

In the event that an LNG cargo fails to conform to the defined quality specifications, the remedies available to the parties will depend on (i) the extent to which the LNG cargo does not match the quality specifications; (ii) whether the buyer is able to satisfactorily treat such LNG cargo; and (iii) the point at which the buyer is made aware or becomes aware of the fact that the LNG cargo does not conform to specifications.

Where the seller knows that the LNG cargo is off-specification before it has been delivered to the buyer at the delivery point, the seller is obliged to notify the buyer of the extent to which the LNG cargo is off-specification as soon as reasonably possible. The LNG SPA usually requires the seller to take all reasonable steps to remedy the off-specification event. Some LNG SPAs go as far as to impose an obligation on the buyer to use reasonable efforts to attempt to take delivery of the off-specification LNG (subject to reimbursement of costs) but the final decision as to whether to accept or reject such off-specification LNG usually rests with the buyer.

If the buyer elects to take and treat the off-specification LNG which has been notified to it in advance, some LNG SPAs grant the buyer a price discount and/or the comfort of an indemnity against loss or damage caused by such off-specification LNG. The protection for the seller is the inclusion of a cap on its liability to indemnify the buyer. Sellers sometimes successfully argue that where the buyer knowingly takes delivery of off-specification LNG, this constitutes a valid delivery of LNG and the off-specification LNG must be paid for in the ordinary course of events, without any concession in favour of the buyer.

In a situation where neither party was aware that the LNG was off-specification at the point of delivery, the buyer will try to ensure that the seller is obliged to indemnify it in respect of (i) any costs or losses related to treating and/or disposing of the off-specification LNG; (ii) the costs of cleaning up the buyer’s facilities (and possibly any end user or third-party facilities for which the buyer is liable); and/or (iii) any death or injuries or other third-party claims for which the buyer is liable. The seller will want to manage its exposure to such claims by negotiating a cap on potential damages. Alternatively, the LNG SPA could provide that the remedy for shortfall in respect of the delivery of LNG volumes could be deemed to apply to the delivery of off-specification gas.