Given the fall in oil prices, many participants in the oil sector have been forced to re-evaluate their investments.[1] A drop in oil prices not only impacts the oil industry; it can also have a significant effect on gas and LNG prices around the world. Many long-term gas and LNG sales agreements continue to peg variables in their complex gas-pricing formulae to oil prices. When oil prices move, the variables in the equation change and the price of gas under the contract is altered.[2]
In agreements spanning 10 years or more, parties may have the ability to revise the contract price if there is a significant change in market circumstances.[3] For buyers and sellers of natural gas and LNG, it will be important to determine whether the recent trends are a long-term significant change that should be reflected in their price formulae.
The fall in oil prices has been stunning. As shown by the graph below, the Brent price has declined by approximately 50 per cent, from over $110 per barrel in June 2014 to just under $60 dollars today.
While there has been a de-linkage from the oil price for some contracts and markets, the contract price in many long-term gas and LNG sales agreements remains linked — at least partially — to oil commodity indices. When the price of oil moves, the price of gas will likely move as well. This is evidenced by the dramatic decline in spot LNG prices destined for Asia. Prices in Europe have also decreased; for example, British prices are 30 per cent lower than on the same date last year. The Henry Hub price, long-considered a proxy for the price of natural gas in the U.S.,[4] is down approximately 49 per cent over the last year.
In these circumstances, buyers under long-term gas and LNG sales agreements may believe that the formula in their contract is not reflecting the extent of the change in oil price, while sellers may believe that the same formula is over-reflecting the change. As a result, either party to the contract may seek to change the price formula to reflect alleged changes in circumstances.
Parties may hotly dispute whether it is appropriate to revise the price formula. The party seeking to change the contract price must usually demonstrate a need to revise the formula by satisfying a test or standard set out in the contract. This is commonly referred to as the “trigger”. For instance, the terms of the agreement might require a party to show that a significant change has occurred in the energy market.[5]
Parties often debate the trigger’s requirements. While parties may rely on economic analysis, this is primarily a legal question. Depending on the provision at issue, lawyers may argue that factors such as a change in the mix of substitute energy sources, the growth of gas-to-gas competition or new, competing sources of supply should be considered. The contract can sometimes require that the change in the energy market be long-term and not temporary in order for the parties to have a right to trigger the price review. Even if not expressly stated in the contract, arbitrators have in some cases inferred this principle.
The causes of the recent trends, and whether these trends are long-term realities, are a matter of debate among economists. Some argue that a decision by OPEC to drive American shale oil producers out of the market has impacted the balance of supply and demand and is only temporary. Others identify weak global economic activity as the primary explanation. Some point out that the markets are becoming more sanguine about geopolitical risk and reassessing its impact on price. For others, the U.S. dollar’s recent appreciation is a key factor.
In the current circumstances, parties contemplating a potential price review should consider these recent trends with a wary eye on the trigger of their price review clause. Showing “change” alone is seldom, if ever, adequate. Parties must frequently show that the change is lasting. This can be a high hurdle. While it is easy to evaluate what has already occurred, it can be difficult to project that these changes will continue to impact oil prices and/or gas markets in the future. For parties considering a price review, it will be important to consider each of the possible economic explanations and determine whether they are significant, lasting changes. The answer may be worth hundreds of millions of dollars.
[1] See our post from October 2014 on the implications of a falling oil price on energy sector investments.
[2] This description is a very simple explanation of how gas pricing formulae work. The reality is much more complex. Formulae vary widely and can include variables for a range of other energy types, inflation and other market forces.
[3] See our previous post for a primer on long-term gas supply contracts.
[4] This thinking may be changing as gas production in other regions of the United States becomes more prevalent.
[5] This is simply one example. Price review provisions in long-term agreements vary and there is no typical clause.