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Focus: Diversion rights in LNG sale and purchase agreements

23 July 2010

In brief: An important aspect of any liquefied natural gas sale and purchase agreement is the extent to which it allows parties to divert LNG cargoes from their original contract destination. Partner Darren Murphy (view CV) and Senior Associate Alison Baxter consider such diversion rights in light of the Association of International Petroleum Negotiators' model LNG sale and purchase agreement.

How does it affect you?

  • As the dynamics of the liquefied natural gas (LNG) market continue to change, the ability to divert LNG cargoes to alternative unloading ports could be important in contractual negotiations.
  • LNG buyers are likely to increasingly seek the flexibility to divert cargoes, to protect against swings in demand and to benefit from fluctuations in spot prices.
  • In contrast, sellers may prefer to limit any diversion rights to protect their own financial interests, as well as to protect against the potential costs and shipping issues associated with diversions.

Introduction

The Association of International Petroleum Negotiators (the AIPN) has published a model LNG sale and purchase agreement (SPA), which includes an optional provision dealing with diversion rights. We will consider the AIPN model provision and outline ten key issues for consideration when negotiating diversion rights.

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Emergence of diversion rights

The first LNG SPAs were drafted several decades ago, paving the way for LNG to be shipped from one location to another and for global trade to emerge. The more traditional form of LNG SPA provides for the delivery of a specified volume of LNG from a specific production facility to a specific regasification facility in another location. As negotiators have continued to seek ways to 'add value' to their LNG SPAs, the contracts have evolved to incorporate contractual rights for the buyer to divert cargoes to alternative destinations. The level of diversion flexibility available to buyers will differ from SPA to SPA.

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Commercial drivers for diversion rights

A threshold issue is understanding why parties seek to include or limit diversion rights in LNG SPAs.

At its simplest, a buyer might want the right to divert a cargo to another location because it may not be able to take that cargo at the contract destination (eg due to technical issues or capacity constraints) or because it may gain a financial advantage by sending that cargo to a different destination.

During the global financial crisis, falling demand in the electricity sector led to lower than expected demand for LNG. The flexibility to divert additional cargoes to alternative destinations in those circumstances enabled buyers to manage their storage constraints without the need to exercise any downward flexibility in their LNG SPAs (if available) and without breaching their obligations to take the contracted volume of LNG. Other examples of where diversion rights may be useful include where force majeure-type events occur at the buyer's facilities or where there are other operational issues that impact upon a buyer's ability to take LNG. While some failures to take LNG may be excusable under an LNG SPA, typically the buyer is subject to a take-or-pay obligation and would prefer to divert a cargo rather than fail to take it.

A buyer may desire diversion rights in order to manage its inventory across a number of unloading terminals, with the flexibility to nominate alternative terminals during the scheduling process.

Diversion rights may also be a useful option for buyers where there is an increase in the price for LNG over time or in particular locations that encourages the 'on-sale' of the contracted LNG cargoes. A buyer is more likely to optimise financial outcomes where it can elect to divert the cargo from the loading port, rather than on-ship it from the original unloading terminal after delivery. From a seller's point of view, it may wish to capture this economic advantage itself, and, accordingly, would seek to restrict the buyer's diversion rights, while preserving its own ability to divert cargoes.

In addition, if the seller is responsible for shipping the LNG cargo, it is likely to have concerns regarding increased costs and ship shore compatibility, which may arise as a result of any buyer-nominated diversion, and is likely to seek to pass any costs on to the buyer.

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AIPN Master LNG SPA provision

Last year, the AIPN published, as part of its model contracts, a 'Master LNG Sale and Purchase Agreement (Delivered Ex-Ship)' model contract, which contains an optional provision for diversion rights. We will use this as a reference point in our discussion.

We note that the AIPN model form is designed for spot sales, rather than long-term sales, and that, by its nature, it is not intended to be comprehensive but, rather, has been prepared only as a suggested guide. We also note that the AIPN model contract is for 'Delivered Ex-Ship' (DES) sales, where the sale occurs at the buyer's facility and the seller is responsible for shipping to that point. The other common form of LNG SPA is a 'Free On Board' (FOB) sale, where the sale occurs at the seller's facility, requiring the buyer to arrange its own shipping. Diversion clauses typically only appear in DES SPAs, while equivalent commercial objectives are pursued through destination restrictions in FOB SPAs. Our discussion is limited to DES contracts.

Summary of key commercial terms of AIPN provision

If the buyer requests a diversion, the seller must oblige if the following conditions are met:

  • The buyer provided written notice of the request within a specified timeframe.
  • If the new voyage will take longer than the scheduled voyage, the seller must have determined that it has sufficient shipping capacity to deliver and return in a 'timely manner'.
  • The buyer warrants that the new destination meets unloading port specifications.
  • The parties agree on a profit-sharing arrangement that:
    • compensates the seller for its reasonable incremental costs, net of the seller's reasonable incremental transportation savings; and
    • allocates the incremental profit of diversion in a 'commercially reasonable manner'.

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Ten key issues to consider when negotiating diversion rights

While there are a number of alternative ways to cast the diversion provisions in an LNG SPA, we have identified ten key issues for consideration.

  • What volume of LNG can be diverted? The AIPN model provision allows any cargo to be diverted where the relevant conditions are satisfied. In a long-term SPA, the parties may limit diversion rights to a particular portion of the contract volume. In this way, there may be 'fixed volumes' and 'diversion volumes' under the one contract. The appropriate limits on diversion is a commercial issue, which will be informed by the specific requirements of the parties and the LNG market at the time of negotiation.
  • Buyer right or seller right? The AIPN model provision provides the buyer with a diversion right. As the seller's financial position is protected through the compensation mechanism, diversion by the buyer will not disadvantage either party in a direct financial sense. An LNG SPA could, however, provide the seller with a diversion right instead of, or alongside, a buyer's right. In other words, the clause might allow the seller to divert a cargo to another higher-paying customer and then allocate the windfall among the original parties. The key consideration with a seller diversion right is whether the buyer is able to tolerate reduced volumes. This will depend on the buyer's physical and commercial arrangements: eg whether it has storage capacity, other sources of supply or the ability to reduce its commitments to others.
  • Diversion to any destination? The AIPN model provision allows cargoes to be diverted to any destination, provided the relevant criteria are met. In practice, sellers may want to restrict the markets into which the LNG can be diverted to avoid adding to supply in those markets: eg in markets where the seller may be promoting a new project, or where it has political concerns. Legal advice should be sought before including such restrictions, as they may contravene competition laws, particularly in the European Union.
  • Other restrictions on diversion? While the AIPN model provision does not prohibit diversions to any specific destinations, it does require the buyer to agree to a profit-sharing arrangement with the seller in order to divert a cargo. This profit-sharing mechanism would also need to be considered from a competition law perspective, particularly in the European Union, as would any restrictions on diversion or on-sale in the LNG SPA.
  • Impacts on pricing provisions? A less obvious matter requiring consideration is the impact of the diversion rights on pricing under the LNG SPA: eg if the SPA includes a pricing adjustment that references prices in the destination market, does the ability to divert cargoes confuse or even alter what market is being referred to? If so, the consequences could be dramatic.
  • Relationship with force majeure and other provisions? It is necessary to understand how the diversion rights will interact with the other provisions of the LNG SPA. For instance, if a buyer is subject to a force majeure event, does it need to utilise the diversion right (eg to mitigate the effect of the force majeure event) and find another buyer or is it simply relieved of its obligation to take cargoes for a period? A buyer may also have the ability to reduce the contracted volumes of LNG under the SPA in a given supply period. In such circumstances, query whether the profit-sharing provisions should apply to downward flexibility cargoes sold by the seller.
  • Allocation of profit? The AIPN model provision requires a profit-sharing arrangement to be agreed that allocates incremental profit of diversion in a 'commercially reasonable manner'. Parties might prefer to include a more formulaic approach to profit allocation. The model also assumes that a profit will be made by the diversion. In an economic downturn where a buyer may seek to divert a cargo to avoid being in breach of its obligations to take the contracted volume, query whether the seller would be obliged to agree to a diversion and whether any loss sharing is appropriate. For a seller, a minor financial loss in this context may be preferable to a reduction in output at its LNG plant or a stranded cargo.
  • Pre-agreed alternate destinations? The diversion process might be streamlined if the buyer and seller are able to agree, up front, that one or more specific alternate destinations meet the unloading port specifications for a diversion and how any additional shipping costs (if any) will be dealt with. The value of doing so will be justified where there is a sufficient likelihood that such destinations will be used. This might be the case for other regasification terminals under the buyer's control. A buyer might also seek the flexibility to divert to any new terminals that it constructs or acquires the rights to utilise during the term of the LNG SPA.
  • Diversion cargoes as a separate business? If the contract allocates certain volumes to diversions, it is possible to imagine going a step further and requiring the other party to source more profitable destinations for those cargoes. A provision of this nature would effectively place that party in the position of marketing agent for the diversion volume. This gives rise to a host of further considerations, including, from a commercial perspective, who of the seller and buyer would be best placed to perform that marketing function and whether the LNG SPA is the appropriate structure for that function.
  • Practical considerations? Another consideration is whether any agreed diversion provisions will actually work in practice. Are the concepts sufficiently clear? Are the specified cost categories well understood? Are the timeframes for notices realistic? Are the matters that need to be finalised for a diversion capable of being finalised? Each buyer and seller would need to consider the practical aspects in light of its own circumstances.

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Conclusion

As with any commercial provision, particularly in a high-value and long-term contract such as an LNG SPA, the parties will seek to allocate risk and benefit to achieve the optimal outcome overall. If a diversion right would be beneficial to a buyer and cause no harm to the seller (or that risk can be managed), then you would expect to see some form of diversion right included in the SPA. Conversely, if a buyer sees limited value in a diversion (eg it anticipates very little demand flexibility), and a seller is concerned about the risks associated with allowing any diversion, you would expect little time to be spent on this issue during the negotiation phase. The inclusion of any diversion rights, and the extent of those rights, will depend very much on the particular commercial circumstances of the buyer and seller, and the dynamics of the LNG market at the time of the contractual negotiations. Finding the optimal solution for diversion rights requires an acknowledgment of the risks to both parties, and effective communication between buyer and seller at the LNG SPA negotiation stage.

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