Fending off LNG trade risks with ‘back-to-back’ clauses

Driven by frequent extreme weather, geopolitical crises and accelerated energy transformation of major countries, the uneven supply and demand pattern of natural gas has aggravated globally, with prices hitting record highs amidst wild fluctuations.

To stabilise market position and secure domestic demand, Chinese enterprises have in recent years accelerated their procurement of liquefied natural gas (LNG) with long-term sales and purchase agreements (SPAs).

Given increasing LNG imports, importers such as China’s companies are of great importance to effectively identify and prevent trade risks. Based on the features of LNG trade and the authors’ experience, this article introduces how to effectively guard against LNG trade risks with “back-to-back” clauses.

The definition

Back-to-back arrangements refer to an intermediary in a trade chain transferring its contractual obligations outlined in the contract with the upstream supplier to the downstream buyer in the same or similar form, with payment or fulfilment by the supplier as a precondition for payment or fulfilment to the buyer.

Back-to-back clauses are prevalent in LNG mid and downstream markets, where many Chinese importers, as intermediaries, choose to pass on important obligations and responsibilities from their long-term SPAs with suppliers to gas sales agreements (GSAs) with buyers, aiming to effectively transfer risks.

The advantages

In SPA deals, the most common upstream and downstream trade structure is Chinese enterprises acting as intermediaries and setting up gas trading platforms as importers, purchasing LNG from suppliers in the international market and selling it to domestic buyers.

However, as platform companies usually have insufficient assets and bank credits compared to the scale of SPA deals, suppliers will ask the parent company to provide guarantees to ensure their fulfilling capability.

In this way, trading platforms assume the main liabilities and risks of LNG trade, and the parent company will likely be jointly and severally liable as well.

Given their dominant position, upstream resource suppliers often transfer most of the risks to Chinese importers through the take-or-pay mechanism, fixed offtake quantity, and open price formula.

To effectively pass on risks along the trade chain, importers prudently pass on commitments, major rights and obligations and liability clauses from the SPA to the GSA.

The clauses

Chinese importers may consider quoting SPA clauses directly in the GSA, or devise GSA clauses in line with the SPA requirements so that major risks in the SPA are transferred smoothly.

Offtake mechanism. Provisions on offtake quantity in the GSA should match those in the SPA to minimise the risk of non-delivery or inadequate supply. In the SPA, buyers and sellers usually agree on delivery quantity in terms of annual contract quantity, adjusted annual contract quantity, daily offtake quantity, upward/downward quantity tolerance (UQT/DQT), make-up quantity, and quality specifications.

If an importer fails to offtake LNG as agreed, it has to assume the take-or-pay obligation, and even be liable for default.

As trading intermediaries, fulfilling the SPA as importers depends largely on whether buyers can meet gas offtake obligations. Correspondingly, the prerequisite for timely and sufficient supply to buyers is strict fulfillment of the SPA by suppliers.

Therefore, on the one hand, when negotiating the SPA, importers should approach buyers in advance to draw up offtake plans. On the other hand, they should devise supply plans prudently in the GSA to closely match the gas offtake mechanism in the SPA, pass on relevant liability by agreeing on DQT and make-up quantity, UQT and excess quantity, and also set up a force majeure (FM) restoration mechanism.

Force majeure. The scope of FM in the GSA includes events suffered by suppliers, such as irresistible impacts on LNG facilities. Typically, if suppliers cut off LNG supply, importers should still fulfil their obligation to sell and deliver gas.

Since LNG is not an ordinary substitutable commodity, importers may not be able to find alternative sources immediately. The spot market price is also often higher than the SPA price, which undoubtedly poses them great financial and default risks.

By agreeing on clauses of FM events, trigger mechanism and FM exemption in the GSA, the upstream risk will be transferred to the GSA as much as possible, exempting importers from the liability of deficient supply.

Price review mechanism. This mechanism brings both opportunities and challenges for importers. The critical reason why a growing number of Chinese companies choose to establish SPAs is to lock in LNG prices to gain financial benefits. However, with recurring volatility, setting price review clauses in the SPA has gradually emerged as a popular option for suppliers.

Prices and their calculation formulas constitute the core business terms in the LNG trade chain. If the upstream and downstream contracts fail to agree on pricing conditions, or price calculation and formulas differ significantly, the basic commercial balance in the trade chain will be spoiled.

Therefore, importers should keep a keen eye on the price review mechanism, regularly check market changes, incorporate the mechanism agreed in the SPA into the GSA, and keep the trigger point and conditions in line with the SPA to avoid solely bearing financial risks arising from price fluctuations.

Looking ahead to the winter heating season, the LNG market is still riddled with uncertainties. As such, it is suggested that Chinese importers fully study the international gas market, seek professional advice to identify legal risks in advance, and take effective precautions for smooth LNG trading.

Wang Jihong is a senior counsel and Liang Danni is a paralegal at Zhong Lun Law Firm