LNG market upheavals push Asian buyers to seek more legal protection in contracts

Singapore — The price extremes of the Asian LNG market in the past year, due to the pandemic-driven demand destruction of 2020 and winter demand spike of early 2021, created friction between buyers and sellers that are likely to feed into negotiations as more LNG contracts get signed.

Buyers in Asia have found themselves unable to hold suppliers accountable beyond limited monetary compensation for non-delivery of LNG cargoes under a contract, especially when energy security is at stake and the gas is critical to keep the lights on.

Currently, the seller's liability varies widely with each contract, from penalties that cover the buyer's actual losses, or a fixed sum paid by the seller, and counterparties said many older contracts do not even have provisions for legal recourse, or have caps on the supplier's liability.

Hence, buyers are starting to seek more permanent protection in their LNG contracts, at a time when utilities are shoring up infrastructure to meet climate change related disruptions, but are yet to shore up commercial agreements to meet the same challenges.

There is little evidence that disruptions will ease, and with the COVID-19 pandemic continuing to ravage economies, supply chain uncertainties persist.

To breach or not to breach

When COVID-19 hit Asia in the first half of 2020, economic activity from South Asia to China had decelerated and importers declared force majeures on LNG cargoes they could not receive.

At the time, the LNG market was flooded, forcing Platts JKM to plunge to record lows below $2.00/MMBtu. But even though many force majeures were not accepted, sellers had agreed to adjust supply to maintain business relationships.

Nearly nine months later, the situation reversed when cold snaps and supply disruptions caused cargo shortages in North Asia, pushing JKM to record highs of $32.50/MMBtu in mid-January, with LNG freight, Chinese trucked LNG and Japanese power prices all hitting record highs.

For around two weeks, the LNG market witnessed disruptions not seen since the Fukushima nuclear disaster, several traders and market participants said.

Many suppliers diverted cargoes to profit from the high spot price -- in several cases, cargoes that were headed to existing customers -- sending "failure to deliver" or "missing cargo" notices to customers, claiming non-delivery in the stipulated time period.

"Failures to deliver are not unheard of in the LNG industry. Generally, late deliveries are much more common than cargoes that never arrive," Agnieszka Ason, visiting research fellow at the Oxford Institute for Energy Studies and a specialist in energy law and dispute resolution, said.

However, the JKM price spike created strong incentives for sellers to secure extra profit and potentially offer contracted cargoes in the spot market at a higher price, instead of delivering them to lower-price term contracts, Ason said.

"Arbitrage opportunities related to record-high spot prices might have aggravated the problem of LNG shortfalls under term contracts," Ason said.

The arbitrage was a record high -- with oil-linked term cargoes at $8/MMBtu and spot cargoes at $32.5/MMBtu, suppliers could make a huge margin even after paying a penalty equal to the oil-linked price.

Review of contractual arrangements

The disruptions of January 2021 did not last very long and utilities and gas distributors were able to dip into inventories to ride out the storm.

Several South Asian buyers, who had received "failure to deliver" notices were compensated at oil-linked prices of $7-$8/MMBtu per cargo, which was a win-win for both sides, traders said.

No major legal disputes arose, according to arbitrators in Singapore, and sellers addressed customer concerns by promising concessions at a later date; or simply apologizing for delays.

However, the two-week scramble was significant for several reasons -- many diverted cargoes were under long-term contracts, and suppliers that profited from the situation included major traders, oil majors and national oil companies, people involved in the transactions said.

This has raised concerns about the reliability of long-term contracts and buyers have been seeking ways to protect themselves from future under deliveries.

Ason said long-term contracts remain the cornerstone of reliable LNG supply and it is unlikely that incidental failures to deliver will have a major impact on the general perception of the sanctity of contracts in the industry.

"But the spotlight on the issue of shortfall LNG under term contracts could trigger a review of contractual arrangements, which are applicable in such circumstances," she added.

These reviews become important as more contracts expire.

"Platts Analytics expects to see a significant amount of new contracts needed in order to replace the contracts that are expiring over the next decade," Jeff Moore, manager, Asian LNG Analytics at S&P Global Platts, said.

"Asia Pacific is the region with the majority of net contract expiries versus 2021, with more than 70 million mt/year of net contracted capacity expiring by 2030," he said, adding that some of this is likely to be re-contracted, but for shorter durations, smaller volumes and with more flexible terms, helping underpin spot liquidity.

"To-date, the desire to maintain a good business relationship has ordinarily prevented sellers from moving term cargoes to the spot market in breach of their delivery obligations," Ason said.

"With the growth of LNG trading and improving arbitrage efficiency in LNG markets increasingly attracting various new actors, the focus will necessarily shift to contractual arrangements offering protections against shortfall LNG under term contracts," she added.