Pricing Arbitrations: It’s A Gas, Gas, Gas

As has been widely reported in the industry, there has been a spate of gas price arbitrations in which buyers have largely succeeded in having contract prices revised in their favour, sometimes by hundreds of millions of dollars.1

This article looks at the theory underlying price variation clauses, and how to approach a question about the meaning of an individual clause. The approach that a tribunal may take to such clauses may be informed by going back to basics, looking at the very reasons for having such a clause, before considering some of the mechanisms that the parties might employ. Practically, though, it should be borne in mind that what ultimately matters is the specific wording of the clause (or draft clause) in front of you, rather than what was decided about a different clause in another award.

Why have a price which changes?

A typical gas sales agreement ("GSA") provides for the sale and purchase of a minimum quantity of gas each year for 15-20 years, or the producing life of the field, with a provision for the price to change in certain circumstances. In theory, however, a producer could agree to supply, and a buyer to buy, a given quantity of gas every year for the next twenty years for a fixed price.

One obvious reason why parties might instead want to provide for the price to change is to account for inflation. The cost of labour and materials to operate, maintain and eventually decommission the field can be expected to increase in line with background inflation. The profits of a supplier that is paid the same price throughout, will tend to fall inversely to this inflation.

This is addressed by providing for price to be adjusted periodically according to a published measure of inflation. Overall, the effect should be neutral. The buyer pays more for gas, but will also be charging its customers more. Disputes will only arise if the relevant index ceases to be published, or the way it is calculated changes.

Assume, then, a contract which still provides for a fixed price at the outset, but also makes some provision for it to increase in line with inflation. It can be seen that, if, in the next 20 years, the realisable value of the gas to the buyer rises relative to the contract price, the buyer will reap all the rewards. If the realisable value of the gas to the buyer falls relative to the price, the buyer will suffer all the loss.

What would the initial price be? The producer must charge enough to cover:

the cost of capital assets used to produce gas (wells, production hardware, pipelines); interest on loans it used to buy those assets; and the likely cost of operating, maintaining and decommissioning those assets (with a contingency for geological, operational and regulatory risk). That is the minimum price any (sensible) producer will agree to. The result is a low risk for the producer. It will earn a guaranteed, inflation-adjusted minimum return for the next twenty years, insulated against any loss. Since the producer's risk is low, it can expect a commensurately low return. The initial price will be set at such a level as to provide the supplier only a small profit.

A producer might have more appetite for risk, and wish to share in the benefit of any increase in the realisable value of gas. The only way to reallocate the risks and rewards is to provide for the price which the buyer must pay the producer to change as realisable value changes. That value depends on what the gas is for.

What is the gas for?

When looking at a price variation clause and trying to work out what the parties' bargain was it is also relevant to ask what the buyer wanted:

A domestic gas supplier buys gas to sell to the domestic end consumer to use for heating and cooking. Such a company usually has long term commitments in terms of infrastructure and maintenance. Its customers' demand for gas is relatively price inelastic - they cannot easily shift to using electricity if the relative price of gas increases. Domestic gas supply may also be regulated, to...