Long-Term Take-Or-Pay Contracts Guarantee Security

¶ … Long-Term Take-Or-Pay Contracts Guarantee Security of Gas Supply?

Given the potential effects of long-term take-or-pay contracts in the gas industry, it is not surprising that this topic has been the focus of an increasing amount of research and attention from scholars and the business community alike, with some observers suggesting that this issue represents one of the more compelling issues confronting the natural gas industry today.

Indeed, recent years have been characterized by increased attention to take-or-pay agreements in the natural gas industry, with special attention being focused on the optimum length of natural gas contracts and the perceived advantages and disadvantages of differing contractual lengths.

Despite this increasing amount of attention from scholars and the natural gas industry alike, there remains a paucity of timely and relevant studies concerning take-or-pay contracts and whether they live up to their intended purposes; moreover, there remains a fundamental dearth of recent research concerning the reasons for an apparent trend towards reduced contractual lengths for take-or-pay agreements. In this regard, Petrash emphasizes that, "There [does not] seem to have been any examination of why contract terms appear to have shortened, the advantages and disadvantages of shortened terms, and whether action can or should be taken to alter the status quo."

Therefore, an assessment concerning how long-term take-or-pay contracts guarantee the security of gas supplies represents a timely and valuable enterprise.

1.2

Government responsibility for the security of gas supplies. While sovereign governments have a fundamental responsibility to ensure the security of gas supplies as part of their overall public service role with respect to national security, Pedros and Cocciolo suggest that the best interests of the United Kingdom government would be better served if it participated in collaborative efforts at the European Union (EU) level to ensure that a robust and harmonized solution is developed for the country's -- and the EU's -- future natural gas requirements. With more than 50% of current EU natural gas supplies being imported, this is a pressing issue.

In this regard, Pedros and Cocciolo conclude that, "Given the EU's common requirements and the global dimension and scope of the issues at stake, security of supply concerns should be dealt with jointly at the European level to strengthen collective negotiating capacity."

By contrast, Grigoryev reports that, "The UK has been a liberalization champion, the question becoming more pertinent after it became a net-importer of gas in 2005, whilst the continued gas price rise over the past two years has been blamed on the non-liberalized European market, where certain suppliers have been using their market power to artificially increase the price of gas in the UK."

The issue of an uncertain marketplace for companies competing in the natural gas industry is therefore directly related to issues of regulatory commitment. In this regard, Brousseau and Glachant point out that, "If a firm has an investment choice that will result in a return only at some future date, lack of commitment by the regulator to enable recovery of the investment may result in the abandonment of a cost reducing investment. Where it is possible to write some form of binding contract upheld by both parties or some third party (such as the introduction of judicial reviews in the United Kingdom) the time inconsistency problem may be mitigated."

In fact, these authorities cite that "infamous example of stranded assets has arisen as a result of regulatory reform in the UK gas industry" as indicative of this need, and add, "The incumbent monopolist signed several take-or-pay contracts which committed it to paying for gas supplies even if they were not used. As competition was introduced the incumbent lost large portions of its market, especially for industrial consumers, and found itself committed to pay for gas which it could no longer sell."

2

Long-term take-or-pay contracts.

The primary purposes of take-or-pay contracts are: (a) allocation of risks (e.g., sharing and transfer of risks) and (b) to help ensure predictability. An analysis of data sets for various periods in the history of gas contracting conducted by Brousseau and Glachant found that, "Take-or-pay obligations varied with the alternative value of gas reserves, supporting an incentive interpretation over the alternative view that take-or-pay provisions served distributional or risk-sharing purposes."

2.1

Definition (nature). Unlike take-and-pay agreements that require a payment from the seller to the buyer if some product is delivered, take-or-pay agreements, in general, "refer to a contractual obligation between the purchaser of a facility's output and a company in which the purchaser agrees to make payments to the company for the good or service producible at the facility in return for maintaining the capacity to produce and deliver the good or service."

According to Culp, "A take-or-pay contract, for example, is a contract that allows a firm to purchase some amount of a commodity at a fixed price and at a variable rate over time. The only requirement is that the entire amount of the commodity must be drawn down by the end of the life of the contract, else the customer pays anyway."

Take-or-pay contracts are commonplace in the natural gas and oil industries, and Culp cites a typical example thusly: "A take-or-pay contract might call for the delivery of one million barrels of West Texas Intermediate crude over two years at the fixed purchase price of $25/barrel. The buyer can choose the schedule for delivery, which can be as flexible as the buyer's needs dictate -- ranging from all million barrels in the first month to all million in the last month to equal monthly draw downs."

The take-or-pay contract is essentially a series of long call options spread over time to allow for flexible deliveries plus a written call option on the unpurchased amount at the end of the life of the contract. Take-or-pay agreements typically stipulate that customers are committed to certain minimum monthly expenditures irrespective of their actual requirements, and these types of agreements are commonplace in the gas industry.

2.2

Elements of take-or-pay agreement. Some of the major components of gas purchase contracts include those described in Table 1 below.

Table 1

Common Elements of Gas Purchase Contracts

Element

Description

Purpose and scope of the agreement

This element sets forth what is to be accomplished pursuant to the agreement, including who will supply the gas, how it will be transported, and who will receive it upon delivery. Other comments may be included in this element, including the potential use of the natural gas, whether a sole provider is involved and so forth.

Definitions

As the term indicates, this element delineates the standard and specialized terms that are used in the contract; because of the specialized nature of the natural gas industry, this is an important element.

Terms of the agreement

This element establishes how long the agreement will be in effect and what types of conditions will serve to terminate it. Other information that may be included in this element are provisions for extending the contract beyond its original terms.

Quantity

The specific details of the agreement concerning the total quantity of natural gas being sold and delivered pursuant to the contract are included in this element. According to Turner, "If there is any take-or-pay language, this is the section for it. Take-or-pay is an agreement for the buyer to pay for gas if contracted but not taken."

Price

This element sets forth the price that will be paid for the natural gas and may include statements concerning price escalators and/or a means whereby the original price can be renegotiated.

Transportation

This element stipulates how the natural gas will be transported and who will bear the transportation costs. Some of the critical points that should be included in this element include:

1. Who is responsible for arranging for the transportation;

2. Who will pay for the transportation;

3. Whether the transportation will be on a firm or interruptible basis; and,

4. Any special conditions on either the part of the buyer or seller that could disrupt the delivery of natural gas.

Delivery point(s)

Because the delivery point or points vary from situation to situation, it is important that this information be set forth in this contract element.

Measurement and quality

This element is used to stipulate the methods, conditions and timing that will be used for measurement and quality, as well as the authority for such actions.

Billing

This element sets forth the terms for payment, including who is responsible, as well as the manner and methods by which payment will be made.

Force majeure

This final element (discussed further below) provides protections for both buyer and seller in the event unforeseen circumstances that are beyond their control prevent conformance with the provisions of the agreement.

Source: Turner 2004, pp. 592-593

2.2.1

The off-taker agreement. Pursuant to a take-or-pay contract, "The off-take purchaser makes payments for capacity whether or not the project company actually generates the good or service at the purchaser's request. The payment obligation of the buyer for the capacity component is unconditional."

2.2.2

Allocation of risks. The purpose of the take-or-pay clause is to allocate the respective risks of the production and sales of natural gas between buyers and sellers.

According to Gaille, "The seller bears the risk of production. To compensate seller for that risk, buyer agrees to take, or pay for if not taken, a minimum quantity of gas. The buyer bears the risk of market demand. The take-or-pay clause ensures that if the demand for gas goes down, seller will still receive the price for the contract quantity delivered each year."

Although there are other salient risks involved, the two main risks hedged against are the two described above.

2.2.2.1 Transfer of volume risk. According to Meyer, Myers, Kolbe, Leonard and Baker, "Take-or-pay contracts are often signed in transportation industries precisely to shift risk of revenue variances away from the suppliers who have sunk costs in the right-of-way to the suppliers of the operating services or shippers who are presumably more knowledgeable about their future demands or better able to bear the risks."

2.2.2.2. Price risk. There are a number of risks associated with longer gas contract terms. For instance, longer contract terms create situations in which natural gas utilities possess excessive transportation capacity for future needs; consequently, gas-supply contracts that cover long-terms contracts can also create a situation in which buyers pay prices during out years that exceed existing market levels.

In addition, longer term agreements can create situations in which gas companies are obligated to produce levels that exceed future requirements, primarily as a consequence of retail-choice programs and market changes. Because of the fungible nature of natural gas, though, the price risks that are associated with longer term contracts are probably less than the prices that are associated with holding pipeline capacity in excess of future needs.

2.2.3

Distortion of obligation by seller and buyer. Distortions in the size of take-or-pay contractual provisions can substantially reduce the commitment on the part of the parties to the contract to advance any additional support for the interpretation of incentive take-or-pay contract provisions.

Moreover, the research to date involved the application of minimum purchase requirements for coal, petroleum coke, and bauxite, among other products, have substantiated this assertion.

2.2.3.1 Adaptability of take-or-pay obligations. The obligations that are created by take-or-pay contracts compared to those created under a take-and-pay contract are described by Giorgio thusly: "Market risk is often met by 'take or pay' contracts whereby the ultimate customers unconditionally commit themselves to make specific payments for a given period of time, regardless of whether they take delivery. A 'take and pay' obligation is somewhat softer, depending on the actual delivery of the resource."

2.2.3.2 the effect of force majeure. According to Black's Law Dictionary, force majeure means "in the law of insurance, superior or irresistible force. Such clause is common in contracts to protect the parties in the event that a part of the contract cannot be performed due to causes which are outside the control of the parties and which could not be avoided by the exercise of due care. An oil and gas lease clause that provides that the lessee will not be held to have breached the lease terms while the lessee is prevented by force majeure (literally, superior force), from performing. Typically, such clauses specifically indicate problems beyond the reasonable control of the lessee that will excuse performance."

2.2.3.3 Make-up and carry-forward rights. The notion that a more liberalized market would provide the UK with increased security of natural gas supplies was advanced by the UK government in 2002; however, despite the fact that the UK has enjoyed a gas market that has been completely liberalized for a number of years, approximately 70 per cent of all natural gas supplies continue to be produced pursuant to long-term contracts.

According to Grigoryev, "These long-term contracts ensure a stable supply yet create barriers to entry for new player wishing to enter the market. Unless the whole European continent moves towards a fully liberalized and competitive market, single liberalized demand centers such as the UK will be affected as a result of the concentration of power further up the supply network."

Based on his analysis of the UK natural gas market, Grigoryev maintains that it is reasonable to suggest that such long-term natural gas contracts will probably experience some changes in the future, with some traditional provisions being reevaluated and revisited for renegotiation. In this regard, Grigoryev advises, "Some of the centrally important clauses such as duration/period which will see a decrease from the frequently encountered fifteen to twenty-five years to perhaps eight to twelve years in length. Take-or-pay obligations will also become less stringent, with increasing 'carry-forward' and 'make-up' rights. Index or commodity pricing, although very common, is being replaced in highly competitive markets by daily pricing derived from a liquid short-term market, such as the UK National Balancing Point."

3

Security of gas supply

3.1

Definition and nature. Long-term take-or-pay contracts offer a comprehensive framework in which the interests of both upstream and downstream parties in the gas industry are safeguarded.

According to Glachant and Hallack, though, "Of course, investments in production and transmission often had an element of asset specificity, exposing upstream investors to predatory 'hold-up' practices; however, by spreading the risk and combining credible long-term incentives, this type of contract allows an alignment of the interests of the partners and a convergence of expectations regarding reciprocity in their behaviour."

3.2

Security of supply obligations under take or pay (the obligation of each party -- buyer or seller) depends on the specific provisions of the take-or-pay agreement. The contracting parties agree on the move and vesting risks. These risks define the obligations of the parties (e.g., buyer bears volume risk and therefore has the obligation to a specific volume of gas off the seller, at specific intervals, which is usually annually).

3.2.1

Buyers' obligation. Although contractual terms differ, under the terms of conventional take-or-pay contracts, the buyer bears the volume risks and so on and must purchase product when due.

3.2.2

Sellers' obligation. As with the buyer's obligation, the sellers' obligations likewise also vary. For instance, sellers could be forced to bear price risks and so forth. It should be noted as well that the risks that are not expressly transferred by the buyer are borne by the seller.