Long-Term Take-Or-Pay Contracts Guarantee Security Research Paper

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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.

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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.

3.2.4

The role of regulation in balancing the market. In both natural gas and transportation services long-term contracts, there are a number of benefits that accrue to consumers based on the long-term nature of the agreement for either natural gas or for transportation service; however, such contracts also involve certain risks. In this regard, Petrash advises that, "The risks of long-term contracts were addressed head-on in the 1980s when long-term natural gas purchase contracts containing take-or-pay clauses created huge tumult in the industry. These events, and perhaps others, make clear that, if regulators should decide that long-term contracts are beneficial to consumers, they must also acknowledge and plan for the risks associated with them."

3.2.5

How regulatory responsibility is transferred and implemented by contracts. There has been some important activity in the UK in recent years that indicate some controversy exists concerning how regulatory responsibilities are transferred and implemented by take-or-pay contracts. In this regard, a competition memorandum from Lexecon reports that, "British Gas has been running a publicity campaign alleging that it is the victim of unfairness. British Gas is obliged to purchase large volumes of gas at well above current market prices under its 'take or pay' contracts with North Sea oil and gas producers."

Furthermore, the company argues that it is being placed at a competitive disadvantage in those situations where competition in the domestic gas market is introduced in ways that are hampering its viability as a competitor. From the perspective of British Gas, "Those take or pay contracts are a legacy of the pre-deregulation period when it was under an obligation to supply the entire market. The government has since changed the rules of the game by introducing competition earlier than originally scheduled."

It is the position of British Gas that the government's inherent regulatory responsibility must take current market conditions into account and that it must take more aggressive action in the immediate future in order to revise the untenable aspects of the status quo to eliminate these disparities. In this regard, the competition memorandum from Lexecon concludes that, "British Gas's shareholders are in effect being unfairly saddled with a financial burden, not of British Gas's making, which the government and industry now have an obligation to address."

4

The impact of long-term take-or-pay contracts on security of gas supply.

One of the primary attributes of take-or-pay contracts is the security and predictability they provide. At their basic level, take-or-pay contracts are simply credit enhancement mechanisms that create an unconditional obligation on the part of the buyer to pay even in the event no goods or services are provided, thereby helping to ensure the long-term flow of revenue and the concomitant security of….....

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