The Main Issues In International LNG Sales Contracts: Susan Farmer.

The following are extracts from a presentation to the 15th Annual APS Conference of Feb. 16-18 in Tehran by Susan Farmer, Partner at the law firm Denton Wilde Sapte:

Expansion of LNG trade beyond the traditional buyer base requires sellers to deal with different types of buyers and markets, and requires acceptance of a different allocation of contract risks than before.

LNG sellers are being asked to consider a variety of pricing terms depending on the particular situation in the buyer's market, including tolling arrangements, where the price paid for LNG/gas is tied to the revenue received for the electricity generated; netback prices based on the buyer's realised gas resale prices; prices indexed to competing fuels, including fuel oil, gas oil and/or coal and/or local electricity indices; and as in the US, NYMEX quoted gas prices.

Increasingly new LNG buyers are less creditworthy than the traditional financially strong monopoly utility and energy company buyers which supported the first generation of LNG sales. New types of buyers include project-financed independent power projects ("IPP") which are either dependent on tariff revenue payable pursuant to a power purchase agreement ("PPA") by a state electricity board or selling into a competitive electricity market without long term fixed price electricity offtake commitments.

Difficulties which may arise for long term fuel suppliers in the first situation are illustrated by the current problems with the Dabhol IPP in Maharashtra, India.

Buyers are increasingly less willing or able to interpose large balance sheets between themselves and their resale market risks, thus requiring sellers to expend significant resources to understand the risks and then to identify strategies for their mitigation. How can sellers protect themselves from these risks?

NEW LNG BUYERS: Many new LNG import projects in non-liberalised state controlled electricity markets will be dependent on demand from one or more large electricity generators; thus, ultimately a large part of the buyer credit risk ends up being with a State Electricity Board (SEB).

International energy companies are generally interested in participating in LNG import projects to facilitate their upstream (LNG production) and/or downstream (electricity generation and/or gas distribution) investment objectives. Operation of an LNG regasification terminal is not generally viewed as a stand-alone profit centre. Likely participants in such ventures include:

* Construction contractors (international and local); * SEB's; * International energy (electricity and/or petroleum) companies.

The above factors generally result in the LNG seller being required to look beyond the LNG Import/Regas Project for credit support of the LNG purchase obligations. If the LNG Import/Regas Project is a project financed entity or other entity without sufficient creditworthiness to support long term LNG offtake obligations without parent company support, seller will have to be satisfied with the contractual arrangements and ultimate performance security under gas sales agreements and power purchase agreements.

Strong import country Government support for a new LNG import project is essential. In cases where there is a scarcity of foreign exchange and/or the main end-user customer is an uncreditworthy state entity, government guarantees of some or all of the offtake obligations may be required.

Even a full central governmental guarantee may not be sufficient in certain jurisdictions, and multilateral agency support in the form of partial risk guarantees would be required.

Private investors in significant import infrastructure projects such as LNG regasification terminals and LNG fuelled power stations will typically ask for a broad range of assurances from the host Government, including protection from Political Force Majeure events, access to foreign exchange, guarantee of buy out at fair price if Government action interferes with project viability amounting to a termination event, etc. However, Governments are increasingly looking to limiting the extent of their direct involvement in these projects. Fuel suppliers looking to have import project guarantees extended to them will encounter a great deal of resistance.

Import project Governments may be willing to extend assurances to secure investment in infrastructure in their country but they generally have little sympathy for the fuel supplier's position. Their view is that the fuel supplier will still have its resources and can sell the LNG elsewhere in the event the import project cannot or does not perform its LNG purchase obligations.

On the other hand, where the import project Government is required to provide a guarantee of PPA obligations, including project buy-out, for an LNG-fuelled IPP, it may look at the fuel contract as an integral part of the project and require the LNG supplier to agree to novate the LNG supply contract in case of termination of the PPA. Otherwise, it could end up having to purchase an LNG fuelled power station without an LNG supply contract.

Sellers may be negotiating with buyers who are attempting to minimise their project risk by proceeding with phased development of buyer project, e.g.:

* Developing floating regas terminal to establish early operation and protection against possibility of holding a stranded asset;

* Developing limited port facilities initially;

* Developing first phase of end-customer power project using liquid fuel, with development of regas terminal and LNG fired second phase of IPP at a later date;

* Developing of pipeline to serve additional customers through regas terminal from second tranche of LNG import.

Clearly the extent and pace of buyer's project development will impact on the LNG SPA's viability. Negotiation of "early termination" rights in the event buyer project development milestones are not met is a notoriously difficult area.