Petroleum Sales Agreements
Energy, Utilities, Mining and COP28
The petroleum sector, comprising crude oil, natural gas, and liquefied natural gas, plays a pivotal role in heat generation, electricity production, and profit realisation. Consequently, investors, including states, invest heavily in exploration.
Law Update: Issue 363 - Energy, Utilities, Mining and COP28
Yanal Abul FailatSenior Associate,Corporate Commercial
The petroleum sector, comprising crude oil, natural gas, and liquefied natural gas, plays a pivotal role in heat generation, electricity production, and profit realisation. Consequently, investors, including states, invest heavily in exploration. Petroleum and petroleum products are sold upon discovery, production, and refinement, often through varied trading routes such as long-term and short-term sales agreements, financial trades, and exchange futures. Given the volatile nature of petroleum prices, these sales agreements are crucial.
The contractual freedom afforded by English law has positioned it as a favoured jurisdiction for petroleum sales agreements, both in the United Kingdom and internationally. However, a shift towards the law of the Dubai International Financial Centre (“DIFC”) as the governing law for such agreements is particularly evident when at least one of the parties is based in the United Arab Emirates (“UAE”), the Middle East and North African Region, Southeast Asia, or Russia. While the Law on the Application of Civil and Commercial Laws in the DIFC (DIFC Law No.3 of 2004) stipulates the exclusive application of DIFC law within its realm, it permits the resolution of ambiguities through reference to other notable jurisdictions, including English law. So, although the DIFC maintains its distinct statutes, English law profoundly influences them.
DIFC law may imply in petroleum sales agreements terms on title, description, quality, and price. Typically, cross-border petroleum sales are classified as international, which could invoke instruments like the United Nations Convention on Contracts for the International Sale of Goods (the “Vienna Convention”), covering risk allocation and breach remedies. Although many nations ratified this Convention, the UAE did not. However, it may apply where the contracting parties hail from member states. With a view to contract on certain and satisfactory commercial terms suitable to oil and gas traders, parties commonly contract out or limit the application of the Implied Terms of Contracts and Unfair Terms Law (DIFC Law No.6 of 2005) (the “Implied Terms of Contracts Law”), or the Vienna Convention, noting that the extent to which such laws can be excluded may be restricted by law.
While petroleum sales agreements often traverse common terrain, the distinctness of oil, gas, and LNG mandates bespoke contract tailoring. Notably, long-term bilateral contracts command nuanced negotiations. This Article highlights the critical commercial and legal nuances of such contracts.
Form and StructureCrude oil sale and purchase contracts (“Oil SPAs”) vary based on factors such as trade duration, transport method, and delivery type. Besides the Oil SPA, traders require documentation like charter parties, insurance, inspections, and payment methods.
In the UAE, oil is sold via physical and financial trades, drawing diverse participants from oil companies to shippers. While the market traditionally leaned towards physical trades, financial trades, like those under the International Swaps Derivatives Association’s framework, are growing. Most oil is sold on a spot basis and transported by sea. Oil SPAs typically divide into ‘special provisions’ and General Terms and Conditions (“GTCs”), with initial negotiations often conducted informally before finalising detailed terms. This formulation mirrors the spot market’s speed, where parties initially agree on basic terms via phone or email and later finalise other details.
Despite crude oil’s global trade, no standard Oil SPA exists. Institutions like the Energy Institute have made standardisation efforts, publishing GTCs for crude oil sales under FOB and CIF terms. These GTCs can be included in FOB/CIF contracts and are usually supplemented by contract confirmation. Major oil companies, however, often draft their unique GTCs. Although they vary in approach, they are typically standardised in form. The Abu Dhabi National Oil Company's (“ADNOC”) General Terms and Conditions for the Sale of Crude Oil / Condensate and Liquefied Petroleum Gas (the “ADNOC GTCs”) are commonly used in the UAE. ADNOC publishes a range of GTCs governed by English law tailored for international trades or particular markets. Such GTCs address crucial transaction details, like warranties and indemnities, demurrage, and termination, and schedule standard documentation (e.g. letters of credit). When there is a conflict between special provisions and General Terms and Conditions (GTCs), the special provisions typically take precedence and can modify the GTCs.
Accepting GTCs and special provisions at different times can create uncertainty about the contract’s formation date. Under DIFC and English laws, a contract’s terms must be clear and complete for enforceability. If essential components are missing, the contract might be seen as incomplete, allowing a party to withdraw from unfavourable deals easily.
Grade and QualityThe Oil SPA should specify the characteristics of the crude oil being sold, emphasising the importance of quality provisions; any breach can lead the buyer to reject the goods and terminate the contract. As per the Implied Terms of Contracts Law, the crude oil must correspond with its description in the Oil SPA and meet satisfactory quality standards as deemed reasonable based on the oil’s description, price, and other criteria. If sold by sample, it should match the sample in quality and be free from hidden defects. In this context, “satisfactory quality” implies that the crude oil meets standards a reasonable individual would deem acceptable, considering its description, price, and other pertinent factors. This encompasses the oil’s state and condition, suitability for all common purposes, appearance and finish, absence of minor defects, and safety and durability. In practice, governing laws’ implied terms on quality are often excluded in Oil SPAs, which explicitly specify crude oil quality. Quality is usually determined at the load port based on standard practices and accompanied by certificates. Oil SPAs can also reference industry standards like density and sulphur content. It is noted that sellers typically aim to avoid liability for any post-shipment oil quality deterioration.
QuantityOil SPAs emphasise terms related to quantity, specifying both the number and size of cargo to be delivered. The agreement might detail deliveries for one-off transactions or extended periods with multiple shipments. Flexibility in the Oil SPA can be provided through a tolerance percentage or a range of acceptable quantities. These provisions often allow the buyer to make the election and qualify such right by stating that any lifting or exercise of the option is subject to the terminal’s approval. Without explicit provisions, the choice depends on the terms: the buyer under FOB and the seller under CIF.
Delivery, Risk, and TitleThe Oil SPA dictates the terms under which the seller delivers crude oil, including the delivery method and precise location, typically to a buyer-nominated vessel or specific loading point. It is an implied condition under the Implied Terms of Contracts Law (and usually warranted in the Oil SPA) that the seller has the right to sell the crude oil to the buyer free from any encumbrance. The transfer of title and associated risks, like cargo damage or environmental pollution, in the crude oil typically corresponds with the delivery point identified in the Oil SPA. Whilst common law dictates that risk in goods pass upon or from the time of shipment, the chosen shipping terms, such as FOB, CFR, CIF, and DES, define the delivery duties and determine when and where risk and title are transferred.
Under the Implied Terms of Contracts Law, the seller’s primary duty is to deliver the goods (and the buyer to accept them), typically through the physical delivery of the crude oil. In a typical FOB contract, the buyer must nominate a vessel by a specific date, obliging the seller to load the cargo within the delivery period. Failure to do so allows the buyer to terminate the agreement. Conversely, the seller submits essential documents in a CIF contract and must ship cargo within a set period. Any deviation permits the buyer to reject and claim damages. Oil SPAs often use CFR/CIF terms, specifying delivery or shipment periods, or both. They also set a laycan period for vessel arrival at the loading port. Delays by the seller can lead to demurrage claims. Buyers must tread carefully when declaring default due to late shipment, as sellers might have the right to extend shipment periods with price deductions, noting that a buyer's premature contract termination attempts could be deemed a repudiatory breach.
Price and PaymentUnder both DIFC and English laws, the Oil SPA can either fix the price or leave it to be determined by agreement or past dealings. If unspecified, the DIFC Contract Law (DIFC Law No.6 of 2004) implies that the buyer must pay a reasonable price, typically equated to the prevailing market rate. However, determining a “reasonable price” is subjective and can lead to disputes. Thus, Oil SPAs commonly set a price or a method for determining the cargo’s price. This typically includes specifying a reference benchmark, designating the days used for computing the average value of this reference, applying a price difference based on the specific terms of the agreement, and incorporating provisions for automatic price adjustments if the quality of the delivered crude oil deviates from the agreed-upon standard.
The seller invoices the buyer based on the quantity mentioned in the accompanying bill of lading. Payment, often in US dollars, should match the Oil SPA’s terms and typically be made within 30 days via telegraphic transfer. If original shipping documents are unavailable at payment time, Oil SPAs may necessitate a letter of indemnity to cover potential losses.
Quantity and NominationsNatural gas sale and purchase agreements (“GSAs”) usually specify that the buyer determines, within set limits, the quantity of gas needed on particular days, with neither party obligated to exceed these set limits. Deliveries typically occur at a consistent rate. Some GSAs necessitate binding monthly, weekly, or even hourly nominations from the buyer in advance, although flexibility exists for different nomination periods. Some GSAs even offer the buyer an option to modify the annual contract quantity for future deliveries. Similarly, in LNG sale and purchase agreements (“LNG SPAs”, together with GSAs, “SPAs”), delivery obligations might detail the LNG’s delivery location, with specifications for downward flexibility. The seller’s decisions often depend on whether the sale is DES or FOB, with FOB sellers facing greater risks related to shipping capacities, especially when buyers adjust their requirements.
Delivery, Risk and TitleSPAs commonly detail a specific delivery point, usually a specific location, where title, property, and risk transition from seller to buyer. Some GSAs accommodate multiple delivery points under specified conditions. If the delivery point is beyond a gas transmission system (“GTS”) exit point, the ownership of the connecting pipeline must be clear. Standard provisions ensure the title of the gas passes at an agreed delivery point. This aligns with the Implied Terms of Contracts Law, suggesting the title transitions when the gas becomes ascertainable and is no longer commingled with other gas. Typically, the risk passes simultaneously with the title when the gas reaches the delivery point.
Where there is a delay between the gas or LNG leaving the seller’s possession and its delivery, sellers may propose that risk transitions to buyers once carriers take possession. This is concerning for buyers, who often demand protection against damages resulting from delivery failures. Non-delivery circumstances vary:
Permissible Failure: The seller can justifiably withhold delivery.
Relieved Breach: A failure to deliver is a breach of contract, but sellers can claim relief, like in force majeure cases.
Unrelievable Breach: A failure to deliver is a breach of contract, but the Seller cannot claim relief, rendering it liable.
Excess, Over and Shortfall Gas DeliveryTo assuage buyer concerns, many contracts include clauses holding sellers accountable for delayed or undelivered cargo, granting buyers the right to end the contract and claim damages. Sellers hesitate to accept this in depletion agreements since they are linked to a sole gas or LNG source. Other provisions, like mitigation processes for buyers, limits on liability, and explicit breach definitions, can be incorporated to address non-delivery.
Long-term SPAs often prioritise annual delivery obligations rather than examining each shipment. This method works best when dedicated shipping lines exist, and the parties have a symbiotic relationship. Short-term GSAs, with their sporadic shipments, differ. Sellers are expected to notify buyers about anticipated delivery discrepancies. If rescheduling is viable, sellers might bear some related costs. If an agreement is not reached and deliveries are late, the seller is deemed to have failed. When determining damages, sellers need guarantees against excessive charges, sometimes necessitating external audits, especially if damages exceed predetermined contract amounts.
GSAs sometimes allow buyers to request ‘excess gas’ beyond the agreed minimum, especially during peak demand. While sellers are not mandated to provide this, they generally make reasonable efforts, and buyers often pay a premium. Conversely, ‘over-delivery’ clauses may exist where buyers try to accept extra gas without obligation. If a seller under-delivers, the deficiency is termed ‘shortfall gas’. Acceptable reasons for this can include the buyer’s refusal, force majeure events, planned maintenance, or stipulated tolerances. Sellers might offer reduced-priced gas or financial compensation to address shortfalls, termed ‘shortfalling’. Unsettled concessions might be handled via cash-out or gas-out clauses. Sellers often implement shortfall tolerance or aggregated nominations to limit liability, with the former offering protection against minor missed deliveries and the latter aggregating shortfalls across several nominations.
Take or PayLong-term SPAs, ‘take or pay’ provisions, or minimum bill quantity clauses ensure the seller’s revenue stability. Unlike short-term GSAs, where payment is often for gas ordered, these provisions require the buyer to pay for a predetermined minimum amount of gas annually, whether or not they physically receive it. This quantity is typically a set percentage (60-90%) of the annual contract amount, called the Annual Take or Pay Quantity (ATOPQ). However, if the seller does not provide the gas or LNG, or unforeseen circumstances (like force majeure events) prevent the buyer from obtaining it, the ATOPQ decreases accordingly. Provisions in the SPAs cater to scenarios where the buyer collects more or less than the ATOPQ. Two fundamental mechanisms are make-up and carry-forward provisions. The former allows the buyer to receive any previously paid-for but undelivered gas or LNG in the subsequent year. To protect their investments, sellers often negotiate restrictions on these make-up provisions. The carry-forward provision, conversely, enables buyers to offset excess gas received (and paid for) in one year against the ATOPQ of the next. Sellers generally limit how this can reduce take or pay obligations. Importantly, to avoid misuse, SPAs ensure that excess gas or LNG in one year is first offset against any outstanding make-up gas or LNG before being considered as carry-forward.
Under English law, the distinction between penalty clauses and liquidated damages has implications for the enforceability of “take or pay” provisions. The Supreme Court, in the landmark decision of Cavendish Square Holdings B.V. v Makdessi [2015] UKSC 67, redefined the parameters. Lords Neuberger and Sumption articulated the new standard: a clause is penal if it is a secondary obligation that imposes a disproportionate detriment on the contract breacher beyond the innocent party’s legitimate interest in the primary obligation’s enforcement. Central to this is differentiating primary (e.g., paying a debt) from secondary obligations. This perspective underscores that courts do not review contractual fairness. Consequently, a take or pay clause in an SPA, creating a debt by ensuring gas or LNG availability — even if the buyer does not take it — is seen as a primary obligation and thus not a penalty. Pre-Cavendish, the DIFC Court, in Roberto’s Club LLC v. Paolo Roberto Rella (CFI 019/2013), tackled similar issues. Despite not fully applying common law principles on penalty clauses, DCJ Sir John Chadwick inferred that such penalty clauses had valid commercial reasons, hinting at a potential deviation in DIFC law from the English rule on penalties. Additionally, the DIFC Law of Damages (DIFC Law No.7 of 2005) underscores the concept of liquidated damages, allowing predetermined breach compensation. While ensuring contractual certainty, Article 21(2) of this law serves as a check against excessive, disproportionate sums. It empowers courts to amend manifestly excessive liquidated damages to a reasonable amount, safeguarding against undue enrichment or abuse.
Pricing Gas prices in GSAs traditionally derive from competing fuel indices set for the GSA’s lifespan. Yet, recent market shifts, influenced by factors like increased liquidity, burgeoning LNG supplies, emerging non-traditional gas reserves, and declining LNG demand, particularly in recession-hit countries, have prompted a decline in natural gas market prices. Consequently, many GSAs transition into shorter terms. Balancing long-term energy supply assurances with market price fluctuations remains critical. GSAs and their LNG SPA counterparts typically embrace three pricing strategies: spot market-based pricing, pre-agreed pricing with adjustment provisions, and price review/reopen clauses. To ensure alignment with spot markets, parties pick market indices suitable for their circumstances from the outset. Predetermined “freeze” pricing often emerges as a solution to price volatility, even if there is a risk of the set price differing from the eventual market price. The seller’s knowledge of the product’s end destination is crucial for pricing and handling unforeseen situations, like in LNG SPAs, where diversion provisions account for changes in delivery destinations, affecting contract prices.
Medium to long-term GSAs commonly feature a set price and adjustment mechanism. The set price is initially established and indexed to specific metrics. Price review or adjustment clauses are commonplace due to the potential divergence between contract and spot market prices. The GSA’s objectives and parties’ roles dictate the selected pricing formula and indexing. Sellers focus on securing market-reflective prices that support future investments, like offshore gas ventures. For stability, parties can utilise a mix of indices to buffer against extreme volatility. Buyers prioritise ensuring gas prices align with other competitive fuels, guaranteeing profitability throughout the GSA. For example, buyers typically choose fuels competing with natural gas when supplying power plants.
Price review clauses and reopenersSPAs incorporate mechanisms to adapt when the stipulated gas price formula fails to mirror evolving market conditions. Such provisions grant the parties the discretion to propose a price reassessment periodically. While there is no universal template for these “price review” or “price reopener” clauses, they usually combine a fixed rate and an indexation component. The former pinpoints the price at the SPA’s initiation or the last price review, whereas the latter adjusts based on specific oil product price fluctuations. Activating the clause requires significant economic disparities from initial SPA expectations, with neither party at fault for the price alteration.
Disagreements often arise when determining pricing adjustments. SPAs might enumerate influential factors, but conflicting interests frequently lead to impasses. One party’s price advantage is another’s disadvantage, creating intrinsic tension. To navigate these disputes, SPAs stipulate expert adjudication or arbitration and typically mandate the party lobbying for a price shift to justify their rationale. The diverging interests surrounding price modifications make consensus on triggering mechanisms elusive. Consequently, clauses can be drafted ambiguously, elevating the potential for disputes and subsequent expert intervention. To legitimise a plea for contract sales price amendments, parties must substantiate the proposal as a genuine, uncontrollable response to enduring market value shifts.
Addressing uncertainties emerging from market liberalisation often involves adopting a price formula strategy. When this method ensures a fixed margin for a contracting party, it is termed a “netback price formula.” This structure provides more explicit guidance for price reviews, particularly in evaluating the market value and formula modifications. Notably, wrangles over price review clauses can become protracted and expensive, primarily when foundational disagreements exist about the prerequisites for expert determination or arbitration. Further complicating the landscape are SPAs that restrict information dissemination, potentially intensifying arbitration complexities and frictions. Given the pivotal role of price revisions in SPAs, drafters must articulate the price review clause’s operational framework, incredibly clarifying its intended activation conditions.
Price DiversionRecent amendments in LNG SPAs now grant buyers diversion rights, facilitating profit optimisation while retaining adaptability. These rights empower buyers to redirect LNG shipments to more lucrative markets. However, this introduces uncertainties for sellers, who might remain uninformed about the product’s ultimate destination until post-delivery. Hence, sellers must track buyers’ utilisation of diversion rights, ensuring that resultant prices do not undermine the product’s value. This is especially pertinent if buyers bear diversion obligations.
Some LNG SPAs incorporate provisions to ensure sellers are not disadvantaged by diversions. It mandates mutual agreement between sellers and buyers on profit-sharing from such diversions. This arrangement bolsters the buyer’s flexibility and entitles them to a share of the added profits from rerouting cargoes to destinations not factored into the initial LNG SPA pricing. The profit-sharing mechanism—usually a 50/50 split—is delineated in the LNG SPA, often via a diversion upside formula. This formula accounts for the actual selling price, the contract price, costs incurred, or saved due to the diversion. The usual formula for calculating diversion upside considers the actual sales price, subtracts the contract price and attributed costs, and then adds any avoided costs.
Verifying the authenticity of data incorporated into this calculation is pivotal for sellers. Buyers might withhold certain data the seller needs for validation due to its confidential nature or apprehensions about legal implications like antitrust or competition violations. Given heightened rights or obligations related to diversions on the buyer’s end, the onus intensifies for sellers to ensure no value degradation. The seller-buyer relationship is instrumental in guaranteeing formula precision. Several remedial strategies can be deployed to counter inaccuracies, such as instituting regular external audits, convening periodic meetings for operations review, and specifying compensation for instances when buyers do not fulfil diversion stipulations.
Force MajeureWhen addressing force majeure in an SPA, it is crucial to provide clear definitions and list qualifying events like terrorism and natural disasters. Certain events, such as market shifts or financial difficulties, may not qualify. Some SPAs even include specific instances like legal changes or issues with gas transporters. Ensuring the SPA aligns with the seller’s upstream contracts is a primary concern for all stakeholders. Additionally, the agreement should delineate facilities susceptible to force majeure events, and the buyer should specify terminal destinations.
Collateral support is a standard provision in petroleum sales agreements like Oil SPAs, GSAs, and LNG SPAs, especially in long-term contracts. These agreements place significant payment obligations on buyers and performance obligations on sellers, necessitating such support. The type and extent of collateral support hinge on the parties’ negotiation dynamics and their relative bargaining powers. Both sides desire assurance of the other’s financial capability. Sellers seek confirmation of the buyer’s current and future financial capacity, often validated through credit ratings or parent company guarantees. Conversely, buyers ask for collateral from sellers to protect against non-performance, such as delivery failures, which could result in penalties. The AIPN GSA, being a long-term agreement, offers conditions where parties must prove their financial stability, whether through bank guarantees, standby letters of credit, or other mutually agreed financial securities. Even in short-term contracts or spot market trades, collateral, like letters of credit, is prevalent. For crude oil, frameworks like the ADNOC GTCs mandate or suggest collateral support forms, including parent company guarantees or other financial instruments. Petroleum sale agreements might specify the collateral form or contain a ‘performance assurance’ clause, which can be invoked if either party deems the other’s financial position as unsatisfactory, prompting measures like prepayments or letters of credit.
In the context of the UAE and its significant role in international trades, petroleum sales agreements can vary greatly. Their structure and content are influenced by the characteristics of the underlying commodity, as well as other crucial factors like the trade’s predetermined duration, the chosen petroleum transportation method, and whether the trade involves an actual or nominal petroleum delivery. For long-term transactions in the UAE, petroleum sales agreements are typically tailored to cater to the specific needs of the trade, ensuring they remain relevant for the duration of the contract. Such arrangements in the UAE can either be depletion-based or supply-based. However, with market liberalisation and increasing focus on ensuring consistent supplies, there has been a noticeable tilt towards supply-based agreements in recent years.
While long-term agreements require a bespoke approach, drafting and continuously updating short-term contracts is equally crucial. Given the UAE’s dynamic spot market, these contracts often adopt a standardised format. Major oil companies in the UAE often deploy standard terms as a strategy, aiming to introduce seller-friendly conditions in a form that minimises intensive negotiations. But, sometimes, these standard terms may be overlooked and are scrutinised closely only when disputes emerge. It is common to find sales departments in the UAE processing orders based on outdated or mismatched terms. In certain instances, experienced international traders do not even operate on their stipulated terms, especially when dealing with savvy buyers who have managed to impose their own terms.
Given the complexity and the strategic importance of oil and gas sales in the UAE and its international trading partners, draft persons must have an in-depth understanding of the downstream sector. Familiarity with the nuances and elements of oil and gas sales transactions enables them to craft enforceable agreements that protect their clients’ interests and provide a profitable negotiation framework with counterparties.
Yanal Abul Failat, ‘Petroleum Sales Agreements’ in Emre Üşenmez, John Paterson, Greg Gordon’, UK Oil and Gas Law: Current Practice and Emerging Trends: Volume II: Commercial and Contract Law Issues (Edinburgh University Press, 2018).
For further information,please contact Yanal Abul Failat.
Published in November 2023
