Oil price volatility: 10 points to consider when facing termination or renegotiation of a contract

The fall in oil prices from highs of US$115.06bbl this time last year to a Brent crude oil currently hovering below US$50bbl, has forced all companies in the oil and gas industry – from the major international and national oil companies, through to the independent service companies, to adjust to a new reality. Part of this adjustment has materialised in a new found vigour to cut costs. Financial viability of new production projects (many of which were approved based on a US$80bbl price) are being re-evaluated, organisations are being restructured and relationships between oil companies, contractors (and their sub-contractors), suppliers and governments are being re-examined. The focus is on efficiency, and less on barrels.

This focus on efficiency is putting pressure on existing contracts throughout the supply chain, many of which were agreed during periods of much higher oil prices. What are the options available to a company bound to an unfavourable contract? Should a company proceed with an unfavourable contract or seek to cut its losses? What should a company do when its counterparty may be considering unilateral termination? In this briefing we summarise 10 points that a company contemplating, or a party who suspects that its counterparty is contemplating, terminating or renegotiating a contract should consider.

It may sound obvious, but a comprehensive review of the contract and the reality of the arrangements will help a company identify any grounds for terminating, or opportunities to renegotiate, a contract. Similarly, it will assist a party who suspects that its counterparty is contemplating terminating or renegotiating a contract, identify areas of contractual vulnerability. Companies should have a clear understanding of the key terms of the contract itself (rather than any summary) as this will allow them to determine if any breaches have occurred. They should also be aware of the precise terms of the termination procedure, notice provision and governing law of the contract.

The governing law of the contract will determine how its terms are interpreted and the extent to which any additional rights and obligations of the parties will be imposed into the contract.

This briefing has been considered from an English law perspective. The transferability of the principles discussed will largely depend on the law in question. For example, English law does not currently recognise a universal of duty of contracting parties to perform obligations in good faith. This differs from the position in many other countries, both of civil and common law jurisdictions. Civil law jurisdictions such as France, Germany and Italy, as well as the common law jurisdictions in certain states in Australia, Canada and the United States all recognise some form of overriding principle that when agreeing and performing contracts parties should act in good faith.

Efficient breach is the decision by a contract party that it may be more economically efficient to voluntarily breach its contractual obligations rather than comply with them.

Efficient breach is based on a pure economic analysis of the consequences of breaching a contract. It ignores any obligations of good faith that a contract may place on a party (although, as noted above, there is no general duty good faith under English law) and it fails to consider commercial relationships or reputational risk, which may make this option unattractive.

To determine if a breach of contract is economically efficient a contract party would need to be able to accurately quantify the cost of its breach. Under English law, the principal remedy for a breach of contract is an award of damages. It is a well-established principle that contractual damages are not designed to punish or deter breach of contract: rather they are designed to compensate for loss and should put the injured party in the position it would have been in if the contract had been performed. Accurately quantifying the level of damages that would be awarded, however, is not easy - the contract party would need to quantify the position of the injured party post-breach, and the hypothetical position the injured party would have been in “but for” the breach, and compare the two. The contract party would also need to take into consideration the economic realities of settling or litigating with the injured party.

A further consideration relates to the existence of any exclusion clauses in the contract. Often parties will agree exclusion of liability for loss of profits, consequential loss etc. Recent case law has however, cast some doubt on a party’s ability to exclude liability for a deliberate repudiatory breach of contract. In 2009 it was held that there is a strong presumption against interpreting an exclusion clause as having an effect in such circumstances.¹ However, an obiter statement in a subsequent case² has provided some reassurance on this point, stating that the decision in the earlier case was wrong and that it effectively sought to revive the doctrine of fundamental breach under the guise of repudiatory breach which had previously been dismissed by the House of Lords³.

For the reasons above, detailed legal, economic and commercial analysis of the consequences of a breach of contract should be conducted before a contract party decides to breach an unfavourable contract “efficiently”.

A termination right often overlooked, is the possibility of terminating a contract for repudiatory breach under common law. A repudiatory breach is, in basic terms, a breach of a term of a contract that is central to the performance of the contract, or a breach which substantially deprives the innocent party of the benefits it would have received under the contract. A repudiatory breach gives the innocent party the right to either accept the repudiatory breach, end the contract and sue for “loss of bargain”, or affirm the repudiatory breach.

The most useful facet of repudiation is the fact that it can be based on an anticipatory breach. An anticipatory breach can be either: (i) an outright statement by one party that it will not perform its obligations; or (ii) a party putting itself in a position where it becomes impossible to perform its obligations.

If the innocent party intends to terminate the contract on the basis of repudiation, it must do so clearly and should ensure that its behaviour cannot be interpreted as affirming the contract’s continuing existence. For example, an oil supermajor lost the right to recover its US$15m investment when its counterparty was in repudiatory breach because instead of notifying the counterparty of its acceptance of the repudiatory breach and terminating the contract immediately, it terminated the contract in accordance with the contract’s termination procedure - giving thirty days’ written notice. The high court ruled that termination pursuant to the contract affirmed the continuing existence of the contract.⁴ A contract party in similar circumstances should cover its bases and draft the termination notice broadly, for example the supermajor could have served a notice which accepted the repudiatory breach, and also invoked the termination clause in the case there was no actual repudiatory breach.

While repudiation can be a useful tool for parties looking to exit contracts, not all breaches of contract are repudiatory. Companies should be confident that the other party’s breach does in fact constitute a repudiatory breach before the termination right is exercised. Wrongful termination can itself be repudiation.

Depending on the type of contract being considered, it is possible that the parties may have agreed express terms enabling the contract to be terminated on notice. A company seeking to rely on contractual termination rights should exercise a degree of caution if the contractual right arises on the occurrence of a “material breach”. Despite its frequent usage, the phrase “material breach” is subjective and has to be assessed in context. "Material breach" connotes the concept of significance, as opposed to triviality, but need not amount to a repudiatory breach.⁵

The notice given by a party to terminate the contract should be completely clear as to its purpose, and fully comply with the notice provisions under the contract (regardless of how onerous they may be). In recent years there have been a number of cases that have served as a reminder of the importance of complying strictly with the provisions of the contract when giving notice.⁶ Shell was undoubtedly very mindful of those cases in the dispute discussed above.

Contractual termination rights can be a useful negotiating tool, allowing a party to achieve a reduction in rates. As an illustration, oil and gas services contractors may be willing to cut their margins significantly in order to win work in the current climate. Companies that utilise these contractors should seek a balance between securing project financial efficiency and squeezing margins, as it may unwittingly push a contractor (and its subcontractors) to cut corners to a dangerous extent, or even to the point of insolvency which would critically delay a project and drastically limit any recovery options.

Under English law there is no general principle of force majeure. Force majeure is only recognised to the extent that parties have included a specific clause in their contract.

The purpose of a force majeure clause is to release (or suspend) a party from its contractual obligations upon the occurrence of an event beyond its control. In the minds of many, force majeure is limited to unavoidable and unforeseeable events such as earthquakes, wars or natural disasters. However, the drafting of a force majeure clause may also allow for a much wider application.

Consider the following industry example:

• An LNG producer is locked into a long-term LNG sale and purchase agreement. The sale price is pegged to the prevailing crude oil price.
• The LNG producer’s upstream joint venture partners have partially ceased to supply it with natural gas supply, as a result of the plunging crude oil price, preferring instead to keep the gas in the ground.
• If the force majeure clause in the LNG producer’s sale and purchase agreement is drafted widely enough – for example, if it includes events preventing, hindering or delaying supply of natural gas to its liquefaction plant – the LNG producer may be able to claim that this is covered by the force majeure clause. Aside from the fact that the LNG producer has limited natural gas to liquefy, this may benefit the LNG producer given the reduction in its cash flow from the drop in its averaged received price per Mmbtu.

Attention should then be paid to the effect of a force majeure event. Often the contract will provide that the parties’ obligations under the contract are suspended for the period the force majeure event prevents contract performance. Time limits may also be included which allow for the termination of the contract after a stipulated amount of time, usually six months or more. This could allow the LNG producer to extract itself from an unfavourable contract. However, a force majeure clause will often require the parties to mitigate the effects of the force majeure event, which may in this scenario require sourcing natural gas from alternative suppliers, on the unlikely assumption that uncontracted natural gas of the required quantity is available as a substitute at the pipeline system feeding this liquefaction plant.

In each case, the question of whether force majeure is triggered will depend on the actual wording of the contract. A party to a contract in which a counterparty is claiming force majeure should note that examples where the decline in oil price (and its associated consequences) amount to force majeure are likely to be rare as it is well established under English law that a change in economic or market circumstances, affecting the profitability of a contract or the ease with which the parties' obligations can be performed, is not a force majeureevent.⁷

If there is no force majeure clause, or if the force majeure clause does not cover the situation in question, parties may try to rely on the doctrine of frustration.

The common law doctrine of frustration allows a contract to be automatically discharged when an event frustrating the purpose of the contract occurs, excusing the parties from performing future obligations under the contract. As no one party is at fault, neither party may claim damages for the other's non-performance.

A frustrating event is an event which:

• is beyond the control of either party;
• has occurred after the formation of the contract; and
• renders the performance of the contract by any party impossible, or illegal, or makes it radically different from the original intention of the parties at the time of the contract.

A common misconception of frustration is the belief that if a contract has become uneconomical to perform this amounts to frustration. In reality the doctrine of frustration operates within narrow confines. A contract is not frustrated merely because it has become a bad bargain for one party. For example, a developer claimed that the fall in the property market caused by the recession in the UK meant that minimum prices for property included in the contract were unlikely to be achieved and the agreement was therefore frustrated. The court however, disagreed with the developer – the parties had anticipated the possibility of a property market fall; the agreement provided what should happen if the minimum prices would not be achieved; and there was no reason for the law to bring the contract to an end as there had been no injustice.⁸

A contract will not be frustrated if an alternative method of performance is possible⁹, if the contract is merely more expensive to perform¹⁰, if the seller under a sale of goods contract is let down by its own supplier¹¹, or if there are changes in economic conditions¹². For these reasons it would seem very unlikely if the decline in the price of crude oil alone would amount to frustration. This is something that should be at the forefront of a party’s mind if a counterparty wishes to terminate an unprofitable contract on the basis of frustration.

Take or pay clauses are particularly common in long term gas sales agreements and other off-take contracts. In essence, a take or pay provision requires a buyer to pay for a specified quantity of product, even if it is unwilling or unable to take such quantities. Take or pay arrangements are arguably for the benefit of both the seller and the buyer – the seller is guaranteed a regular income and the buyer is guaranteed a regular supply. In recent years however, some uncertainty has arisen as to whether a take or pay clause could amount to penalty and therefore be unenforceable.

English law renders contractual arrangements which operate to penalise a party from breaching a contract as unenforceable. A penalty should be distinguished from liquidated damages – a penalty primarily operates to deter breach, whereas liquidated damages are a genuine pre-estimate of loss.

In recent case law it has been held “as a matter of principle, the rule against penalties may apply”¹³ to take or pay clauses. In considering if a take or pay clause amounts to a penalty the following factors will be considered:

1. is the take or pay clause oppressive;
2. is the take or pay clause commercially justifiable;
3. is the primary purpose of the take or pay clause to deter breach of contract; and
4. do the parties enjoy equally bargaining power?

The recent case law on take or pay clauses does provide buyers with the possibility of constructing an argument that will allow them to avoid liability under take or pay clauses. Careful analysis of the four factors listed above will be required - to date, despite the English courts acceptance of the principle that a take or pay clause may amount to a penalty, in neither of the two cases that have appeared before the courts was there found to be a penalty.¹⁴

If the contract cannot be terminated pursuant to the options above, a company may consider if it can renegotiate an unfavourable contract.

“Price re-opener” clauses are frequently found in long term off-take contracts within the energy market, particularly in long-term gas or LNG supply contracts. The pricing of such contracts, particularly in Asia, are often linked to oil prices. Although such contracts often contain an S-curve pricing formula, which is intended to alleviate the negative effect of low oil prices on the seller and high oil prices on the buyer, the inclusion of an S-curve pricing formula is unlikely to entirely eliminate the detriment to the seller of a 50% decline in Brent crude oil prices.

In general a price review process takes place in two stages. The first stage in the process involves a “trigger” where the party requesting a price review must demonstrate that the elements for initiating the price review have been satisfied. While there is no model form of price reopener, it is usual for the trigger to be a periodic option to review, as well as a “wild card” option to review. The wild card option could be a change in law, or importantly in this context, the occurrence of unforeseen economic hardship to one party.

The second stage of the process involves a determination of the manner in which the review must be conducted and how it is to take effect. Often the parties will be required to enter into good faith negotiations to effect a fair and equitable price revision. The price re-opener clause should also set out the consequences for failing to reach an agreement.

Price review clause discussions are (unsurprisingly) contentious. In recent years there has been a number of gas price arbitrations which have either proceeded to litigation in court, or been made public through press releases and market commentary. The cases largely stem from the disconnect between the oil price and the gas price – buyers had been forced to pay a price which rose with the oil price, when the price of gas using other indices or benchmarks had fallen. Much depends on the facts of the particular case, but there has been something of a pattern recently of buyers succeeding in having prices revised in their favour. For example, in 2012 and 2013 Edison (the buyer in both cases) was awarded €450m discount and a €300m discount in the RasGas and Sonatrach arbitrations respectively.

Parties wishing to terminate or renegotiate unfavourable contracts might want to consider proposing to its counterparty that they enter into an alliancing agreement instead. Enlightened self-interest may lead parties to seek to propose an entirely reworked solution to the commercial issues confronting them. Perhaps traditional adversarial contracting is no longer appropriate, and could be replaced with a more ostensibly “win-win” solution. Alliancing agreements gained popularity in the North Sea oil and gas industry in the early 1990s – arguably an era similar in oil and gas economics to the present, as a means of trying to achieve quicker and more sustainable outcomes through a collaborative approach, rather than imposing strict contractual obligations.

Alliancing agreements provide an opportunity for operators and contractors to align their interests - project risk and reward can be shared, so that parties can weather the storm together and enjoy upside when both parties make the project a success. In January 2015, BG entered into a single-partner alliance with KBR, under which KBR will provide front-end-loading engineering services, project management expertise, and technical support across BG’s global upstream portfolio. The alliance, which has been signed for six years initially with options to extend to up to 10 years, involves a significant evolution in the way operators and contractors work together. It will enable BG to minimise fixed costs while retaining access to technical expertise and provide KBR with a steady pipeline of income.

The high capital expenditure and the arms-length commercial relationships involved in many oil and gas-related contracts mean that parties usually seek the protection of a strict legal document containing market protections. Alliancing advocates claim this leads to contract negotiations being prolonged and defensive as the operator’s contractual protections merely inflate the contract price. Other commentators make the point that alliancing agreements may not afford financiers the comfort they need to provide capital for high-value projects. There can be no doubt that the difficulties of low oil prices do, call for novel and imaginative approaches and an alliancing agreement could be a worthwhile option.

The decline in oil prices is a phenomenon that looks set to affect the oil and gas industry for some time to come. As outlined above, there are many legal options available to industry participants which may help to manage unfavourable contracts and their associated risk. In order to avail themselves of these risk-mitigating options, companies should closely review their contracts, even those not currently under economic pressure, to ensure early identification of potential issues.