The past three years have seen changes and uncertainty in almost every aspect of people’s lives, as the COVID-19 pandemic and political strife have caused havoc for markets across the globe.
One of the hardest-hit areas has been energy, in particular gas, where prices have fluctuated wildly worldwide over the last three years. The COVID-19 pandemic saw drastic lows as demand dropped during lockdowns, then prices surged in 2021 as increasing demand suddenly led to supply shortages, and prices rose again in 2022 as Russia’s invasion of Ukraine triggered a steep decline in Russian gas deliveries, while key markets experienced higher gas burn amid lower electricity output from other sources like nuclear and hydro.
As buyers around the world rushed to secure alternative gas sources, the price of liquefied natural gas (LNG) skyrocketed. The International Energy Agency reported that in Q3 2022, the cost of LNG had reached its highest level since 2008 in the US and was at an all-time high in Europe and Asia. Indeed, between early 2020 and mid-2022, LNG prices rose more than 40-fold and 20-fold in Europe and Asia, respectively. Although prices have decreased since their peak in mid-2022, they remain high and are expected to remain volatile due to projected supply and demand fluctuations.
These circumstances have led to an increase in disputes arising from LNG contracts, which typically include arbitration clauses, thus bringing arbitration to the fore. In particular, the past few years have seen an increase in arbitrations relating to price reviews and supply obligations, a trend that looks set to continue.
Price review clauses in LNG supply contracts are included to give parties flexibility to adjust their agreements based on market fluctuations, with the procedural and substantive requirements of such a review dictated by the contract. While Europe is no stranger to gas price arbitrations, which it saw triggered first by EU deregulation of the gas market in 1998 and then by reduced European demand and US oversupply after the 2008 global financial crisis, the volatility of the market in the past few years has seen an increase in price review arbitrations in Asia-Pacific in particular, where they were previously rare.
High LNG prices mean that sellers will be turning to price review clauses to seek upward price reviews under long-term contracts, while buyers will be under pressure to keep costs low and resist any price rise. With such diametrically opposed positions and uncertainty in gas market development, the chances of amicably agreeing on price increases appear slim, and so we expect the number of price review arbitrations to increase globally.
The severe market fluctuations and supply uncertainties are also feeding into the desire to break or renegotiate existing LNG supply contracts to profit from higher market prices and secure alternative sources of supply, while supply shortages are making delivery obligations difficult to meet. Increasingly, sellers are failing to deliver all or even part of their LNG commitments under long-term contracts, often citing operational and logistical issues (such as lack of, or issues with, infrastructure), force majeure, hardship and/or sanctions as the justification. This further exacerbates the supply crunch as buyers seek to obtain replacement LNG to fulfil their own obligations to downstream consumers. Disputes arise as the parties seek to assign blame and argue about who bears the contractual risk.
Sellers are also seeking to divert LNG cargoes from existing buyers under long-term contracts to new buyers who are willing to pay more. Given they are typically subject to duties to maximise shareholder profit, sellers may consider it necessary to seek more lucrative deals to supply third parties under agreements negotiated in the more favourable market conditions now existing and accept the consequences of a breach of contract rather than comply with their existing long-term commitments. This gives rise to further disputes, including whether a right to sell to other buyers exists in the contract and, if so, who should be afforded priority.
These disputes will likely lead to buyers seeking to enforce contractual obligations and/or recover damages for the shortfall beyond liquidated damages or other contractual limitations (particularly if the seller refused delivery to achieve opportunistic gains). Where contractually available, claims may also arise from sellers’ violation of buyers’ rights to upward flexibility (ie entitlement to increased quantities for a particular period) and to divert cargo, as buyers would have an incentive to receive the additional quantities for the lower contractual price to store and/or resell elsewhere for the higher market price. As noted above, sellers may invoke force majeure and hardship clauses to justify delivery failures.
Arbitration, with its emphasis on confidentiality and the ability to select tribunal members with relevant industry expertise, is well placed to hear disputes arising from the ‘perfect storm’ of drastic fluctuations in prices, supply shocks and bottlenecks, inadequate infrastructure, and sanctions. The rise in disputes we are seeing acts not only as a warning to those parties not yet facing such disputes, but also as a reminder of arbitration’s unique position – private, tailored and internationally enforceable – to resolve such differences.
‘The energy market volatility and political instability in the world today are upending contractual relationships for LNG sales, and we expect to see disputes arising out of this disruption in almost every corner of the globe as buyers and sellers seek creative ways to improve their positions.’