Risks of importing Russian LNG during war in Ukraine (Part 2)

By Wang Jihong and Liang Danni, Zhong Lun Law Firm
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As mentioned in the previous article in this series, the war in Ukraine has seen the US, EU and other Western countries and regions impose a stream of economic sanctions against Russia, greatly affecting the international trade in liquefied natural gas (LNG) upstream and downstream. The sanctions not only constrain trade in Russia-related LNG sources but also add to the uncertainty faced by Chinese enterprises in their LNG trading, inevitably affecting those having entered into long-term purchase and sales contracts. This article looks at how Chinese enterprises can respond to changes in upstream supply sources, as well as their sanction and export control compliance obligations in the changed situation.

CHANGING SUPPLY SOURCE

Wang Jihong, Zhong Lun Law Firm
Wang Jihong
Partner
Zhong Lun Law Firm

The Office of Foreign Assets Control of the US Department of the Treasury placed Nord Stream 2 on the sanctions list on 23 February. On 8 April, the EU announced a fifth round of sanctions including restrictions on the export of heat exchange equipment to Russia, indirectly affecting the operation and production of the country’s LNG plants. On 26 April, the Polish Ministry of Interior and Administration announced it was placing Russian energy companies such as Novatek and Gazprom on its sanctions list.

More broadly, on 8 May, the G7 declared its members were committed to phasing out their reliance on Russian energy. Under such circumstances, Chinese enterprises that have entered into long-term LNG purchase and sales contracts under which supply sources include Russian LNG projects may face the risk of the seller changing the source of supply or, in worse cases, failure to supply LNG within short order.

Usually, the long-term LNG purchase and sales contracts executed between Chinese enterprises and upstream sellers specify the supply source, including one or more fields in the seller’s resource pool from gas projects around the world such as Australia’s Gorgon, Russia’s Arctic LNG 2, Qatar’s Ras Laffan and Indonesia’s Tangguh. If sanctions explicitly restrict enterprises from the US or other regions from procuring Russian LNG, it is likely the seller will switch to supplying gas from a substitute source, without necessarily securing the buyer’s prior consent.

In view of this risk, the authors advise that after receiving notice from the seller of a change in gas source, a Chinese enterprise should first check whether the specification of the substitute source satisfies the requirements of the domestic LNG receiving terminal and downstream users. Second, Chinese enterprises should reasonably plan gas consumption in advance and maintain close contact with downstream users to respond to any potential supply shortage from the seller and avoid the risk of breach of contract in downstream trade.

For a contract still at the startup or negotiation stage, Chinese enterprises
should closely watch the gas field resources included in the seller’s resource pool and expressly specify in the contract that if the seller changes the supply source for a reason not attributable to the Chinese enterprise, it is required to secure prior written consent. This will ensure, to the greatest extent possible, the compatibility between the domestic terminal and the delivered LNG.

SANCTIONS AND EXPORT CONTROL

Liang Danni, Zhong Lun Law Firm
Liang Danni
Associate
Zhong Lun Law Firm

In recent years, an increasing number of long-term LNG purchase and sales contracts specify the parties’ sanction and export control compliance obligations, requiring the buyer to give undertakings in respect of sanctions, anti-corruption and compliance. Such contractual provisions frequently require the Chinese enterprise, or both parties, to comply with sanction and export control laws, regulations and policies of the US, EU and other countries and regions. These provisions can prohibit the re-export or transfer by other means, directly or indirectly, of the natural gas acquired under the contract to any enterprise, country or region listed on any sanctions list or in any policy.

Generally, compliance undertakings involving sanctions and export control require the buyer to satisfy compliance requirements on an ongoing basis during the term of the contract. Accordingly, the Chinese enterprise will bear an obligation to closely follow compliance developments. If the Chinese enterprise commits a violation of the sanction or control requirements issued by any country, it will be deemed in breach of the obligations to which it committed.

The seller could then file a claim against the Chinese enterprise for such a breach, or even go as far as terminating its performance of the contract requirements, causing the Chinese enterprise to incur financial losses, affect its reputation and trading position in the international LNG market, and indirectly affect the performance of the contracts between the Chinese enterprise and downstream users.

In view of this ongoing risk and given the flood of sanctions issued against Russia, the authors recommend that Chinese enterprises comprehensively review their existing contracts to determine whether the places of registration and main business of both the buyers and sellers involve a sanctioned region, supply source or distribution of main assets, specify the compliance control level of upstream and downstream partners, improve their sanctions compliance risk identification systems for sensitive countries and regions, and track international sanctions developments in real time.

For a contract still in the startup or negotiation stage, if the seller requests more stringent compliance obligations, the authors advise the Chinese enterprise to prudently control its own risks by considering the implementation of similar rights and interests and, where the entire supply chain system commercially permits, include a compensation mechanism passing on the compliance obligations back-to-back to the downstream buyers, adding “act of government” to the force majeure clause in their downstream sales contracts, etc., to avoid bearing excessive compliance obligations.

In general, due to the risks faced by Chinese enterprises in importing LNG during the current unstable international political situation, the authors recommend that professional advisers are engaged to study the sanctions policies and trading precedents, take into account professional legal and financial advice, and fully consider potential changes in the international situation and project requirements in order to arrive at more prudent, well-rounded business decisions.

Read more: Risks of importing Russian LNG during Ukraine war (Part I)

Wang Jihong is a partner and Liang Danni is an associate at Zhong Lun Law Firm

Zhong Lun Law Firm

22-31/F, South Tower of CP Center

20 Jin He East Avenue

Beijing 100020, China

Tel: +86 10 5957 2288

Fax: +86 10 6568 1022

E-mail:

wangjihong@zhonglun.com

liangdanni@zhonglun.com

www.zhonglun.com