LNG market outlook and Covid-19 coronavirus
13 May 2020
Reproduced from Project Finance International Global Energy Report April 2020.
Force majeure has become a much debated subject since the outbreak of the Covid-19 coronavirus. We have seen force majeure being claimed by (a) buyers under LNG SPAs in relation to their obligation to take delivery of scheduled cargos, and (b) under EPC contracts relating to potential schedule impact on LNG projects under construction, which consequently required notifications to lenders under financing agreements.
Given the rapid spread of the Covid-19 coronavirus across the world, and the resulting travel restrictions being put in place by governments, as well as operational measures imposed by almost all market players to protect their staff, we may also start to see force majeure being claimed across the LNG value chain, as operators and suppliers facing increasing hurdles in sending personnel to site and continuing operations as usual.
Here are a few general points that all parties should keep in mind in relation to force majeure.
It’s all down to the contractual terms
Under English law, force majeure is a purely contractual term that cannot be implied. An English court or arbitration tribunal will look at the precise wording and all relevant facts and evidence in determining whether a force majeure event has arisen under a contract and the extent to which a party is entitled to relief as a result of that event.
Definition of force majeure
Force majeure is often generally defined as an event or circumstance beyond the reasonable control of the party affected by it, and includes a non-exhaustive list that includes “outbreak of infectious disease”, “epidemic” and “acts of government”, though the effect of such events will vary from contract to contract.
What relief is available?
The affected party is excused from its obligations to the extent such obligations are prevented (or hindered, impaired, or adversely affected) by the force majeure event – again, this will hinge on the precise wording of the force majeure clause. Force majeure clauses may provide for specific carve-outs of what parties cannot claim as force majeure, for example inability to make payments, financial hardship, or changes in market circumstances.
What does the affected party need to prove?
The party claiming force majeure should be mindful that it will bear the burden of proof for the existence of the force majeure and the causal link between the force majeure event and its ability to perform under the contract, as there is often a reference to the event directly causing the party’s failure to meet the obligation.
Typically, we would expect that an affected party would need to establish, among other things, that (a) the event is beyond its reasonable control, (b) it prevents or delays the affected party from performing its obligations and (c) that the affected party has taken reasonable steps to mitigate the effects of the force majeure event and minimise its losses.
These issues have been key points in correspondence regarding the Covid-19 coronavirus related force majeure. A critical question will also be whether the spread of the Covid-19 coronavirus itself is the sole or direct cause of the affected party’s inability to meet its performance obligations.
Force majeure certificates issued by a government agency such as the China Council for Promotion and International Trade (CCPIT) may be taken into consideration by way of evidence, but, in view of the considerations noted above, is unlikely going to be considered conclusive by the court or tribunal.
A contract will also often provide for a termination right by either party, or sometimes by a non-affected party, if the force majeure event is affecting performance beyond a prolonged period of time, eg 365 days, and will sometimes be subject to thresholds, eg the force majeure affects a specified percentage of the LNG volume to be taken under an LNG SPA.
It remains to be seen whether the effect of the Covid-19 coronavirus pandemic will be prolonged or will affect sufficient quantities under long-term offtakes, beyond individual cargoes currently affected, to justify a basis for termination.
Dealing with force majeure
Given the fluid situation of the spread of the Covid-19 coronavirus globally, we would advise our clients who have ongoing obligations under long-term LNG SPAs to carefully consider their contractual terms and to take practical steps to protect their legal position, as follows.
Relevant contractual obligations
Identify the obligations under their LNG SPA that may be impacted and to what extent;
Implications of current and proposed actions
Look into the implications of any actions that they are currently taking and whether they should be taking any further action in order to preserve their ability to claim force majeure in the future.
Evidence to support a claim
Retain evidence of actions taken, both administrative and operational, to not only prove, but continue to support, a claim on an ongoing basis.
Force majeure notice requirements
Consider any notice provisions that have been triggered, as some notice requirements can be triggered by a party becoming aware of the possibility of a force majeure claim arising. The affected party will need to ensure that the express requirements of the notice provision are addressed, which will be difficult for more detailed provisions which require estimates of duration and the impact of the event.
Likelihood of force majeure notice
Assess the likelihood of their counterparties claiming force majeure and whether these counterparties should be taking additional measures where insufficient preventative action is apparent.
Possibility of reduced quantities
Consider the possibility of reduced quantities being made available and whether the LNG SPA provides for proportionate allocation of the quantities that are available.
Possibility of diversion or sale to third parties
Consider whether the LNG SPA permits cargoes to be diverted or sold to third parties in the case of cargoes that are within, or close to, their respective scheduled arrival window.
Review and assess their insurance policies and engage with insurance providers to ensure that they are able to access these policies in a timely manner. For example, business interruption policies usually respond to business interruption caused by physical damage or loss, and therefore are unlikely to be triggered by purely operational constraints caused by the Covid-19 coronavirus pandemic.
If required under the LNG SPA, take specific steps to overcome/minimise the effects and consequences of a force majeure event, such as using commercially reasonable endeavours to obtain alternative shipping arrangements. In some cases, this obligation to use reasonable endeavours may be applied to both parties. Failure to do so may lead to the affected party no longer being entitled to relief under force majeure.
Resumption of performance
If the LNG SPA allows for undelivered quantities to be delivered during the following contract years upon resumption of normal performance after a force majeure event, consider the impact on LNG production, shipping and the capacities of sending and receiving terminals/ports, as well as the price implications.
Exposure to termination
Should the force majeure event continue for prolonged periods of time, consider whether the LNG SPA is exposed to termination. This, in turn, may lead to price and term renegotiations.
Any agreement signed today will be entered into with full knowledge of the fact of the Covid-19 coronavirus and its potential impacts; therefore claims of force majeure, which will typically consider what a reasonable and prudent operator would do, will need to be considered in this context. Parties may consider expressly addressing what measures need to be taken, in particular in relation to shipping and diversions.
The sharp drop in LNG prices in recent months due to the drop in global demand – and especially demand in China, although we may see increase in China demand as economic activities recover in the coming months – as well as downward pressure on Brent prices has shifted the market even more in buyers’ favour. Spot prices for LNG have hit new lows as diverted cargoes and excess supplies have hit the market.
With inventories at seasonal highs even before the Covid-19 coronavirus, as well as rigid market structures and existing contractual arrangements under long-term LNG SPAs, we are not seeing a significant uptake in additional volumes from Europe, Japan or South Korea despite low prices – a scenario that is likely affected by the impact of the Covid-19 coronavirus on these jurisdictions themselves.
However, sustained low LNG prices will give additional ammunition to buyers looking to renegotiate prices under long-term contracts through price reviews, or outside of those mechanisms – as we have seen in the past, with buyers seeking to apply relationship pressure.
As has been the case with previous buyerfriendly markets, buyers are not only seeking lower prices but also other, more favourable terms in their LNG SPAs, in particular in relation to quantities and scheduling – attempting to position themselves with the option to bring more low-cost LNG into their portfolio, for their own use or to arbitrage, when demand recovers.
Many existing LNG SPAs have prices that, in this market, are considered high. In that context we are seeing parties seeking to take advantage of quantity flexibility and even shipping flexibility to try and maximise, in the case of sellers, or minimise, in the case of buyers, the amount of LNG being delivered.
Given the current uncertainty around the medium-term outlook on LNG and oil prices, and taking into consideration additional supply volumes already scheduled to come online towards 2023–2026 from current projects under development, it is very much still a buyers’ market and has become more so in recent weeks. Developers of new LNG projects that need long-term LNG SPAs to underpin the credit profile of their financing are in a bind.
They can seek commitments now in a buyerfriendly market at lower prices to get to a final investment decision, or put that decision off and risk other projects filling the order books ahead of them.
Arguably, if developers wait, they can secure potentially better terms and conditions as global uncertainty reduces. However, if they move now, they can secure better terms with construction contractors.
Developers will certainly want to consider alternative options, such as minimising LNG offtake commitments entered into now to preserve future flexibility. However, this may require greater equity funding of the project during the initial part of the construction phase.
We would imagine that debt will be looking for a home after the Covid-19 coronavirus is brought under control and as markets seek a road to recovery. Flexibility could be sought to leverage up later using additional debt as additional LNG SPAs are entered into. This strategy comes with some risk; however, as the saying goes, fortune favours the brave.
In LNG project financings that require lenders to take market risk, we have seen in recent years increased pressure on lenders to give credit to LNG sales committed under short and medium-term contracts for the purpose of determining the initial debt capacity of the project as well as additional debt and distributions, due to the increased commoditisation of the LNG market.
Currently, although most financiers and export credit agencies backing such financing will still expect to see most projects’ revenues being underpinned by long-term LNG SPAs, we are seeing the mood shift towards wider acceptance by lenders of short and mediumterm offtake. However, we would expect lenders to take a more conservative approach under the current market conditions. Sound market advice on the robustness of long-term LNG prices will be particularly important in the current environment to get a new project off the ground.
We could see current restrictions on the movement of people and site access starting to impact construction schedules, operations or compliance with obligations under financing documents. It is worth taking a minute to see if this has impacts under any financing documents. For example:
- If a force majeure notification is received from a contractor under a material project contract such as an EPC contract or an LNG SPA, this would normally have to be notified to the lenders promptly, regardless of whether or not the borrower agrees with the force majeure notice.
- While it would be unusual to see a material adverse change (MAC) event of default in LNG project financing documents, parties should consider whether the current Covid-19 coronavirus situation is likely to have a material adverse effect (MAE) on the project, and the relevant representations, covenants and events of default that are qualified by MAE.
This term is usually carefully negotiated and the key aspect parties should consider is whether it is going to materially impair the borrower’s ability to either meet its payment obligations or comply with its material obligations under project documents.
- For construction phase projects and in particular for LNG projects where lenders benefit from debt service undertakings during the construction phase, the key consideration will be whether the current situation is going to lead to a material delay in the construction and completion of the project so as to lead to an inability by projects to pass the lenders’ completion test by the agreed longstop date – including their ability to meet the completion tests related to operation of the plant, LNG shipping, LNG offtake and insurance – although usually some flex is built into such tests and long stop dates to accommodate delays caused by force majeure.
Again, it will hinge on the exact definition of force majeure for these purposes in the finance documents.
- Consider and plan ahead for the potential impact of travel restrictions and restrictions on the movement of personnel, for example on the ability to comply with site inspection, access and monitoring obligations and the ability to get key operational personnel to site; and consider the potential impact on the seller’s obligations to comply with deliveries under its LNG SPAs as well as the ability to perform business operations in order to make payments, not usually excusable by reason of force majeure.
This article was published in Project Finance International’s Global Energy Report 2020.