How Do Long-Term Take or Pay Contracts Guarantee Security of Gas Supply? Research Paper

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¶ … Long-Term Take-Or-Pay Contracts Guarantee Security of Gas Supply?

Given the potential effects of long-term take-or-pay contracts in the gas industry, it is not surprising that this topic has been the focus of an increasing amount of research and attention from scholars and the business community alike, with some observers suggesting that this issue represents one of the more compelling issues confronting the natural gas industry today.

Indeed, recent years have been characterized by increased attention to take-or-pay agreements in the natural gas industry, with special attention being focused on the optimum length of natural gas contracts and the perceived advantages and disadvantages of differing contractual lengths.

Despite this increasing amount of attention from scholars and the natural gas industry alike, there remains a paucity of timely and relevant studies concerning take-or-pay contracts and whether they live up to their intended purposes; moreover, there remains a fundamental dearth of recent research concerning the reasons for an apparent trend towards reduced contractual lengths for take-or-pay agreements. In this regard, Petrash emphasizes that, "There [does not] seem to have been any examination of why contract terms appear to have shortened, the advantages and disadvantages of shortened terms, and whether action can or should be taken to alter the status quo."

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Therefore, an assessment concerning how long-term take-or-pay contracts guarantee the security of gas supplies represents a timely and valuable enterprise.

1.2

Research Paper on How Do Long-Term Take or Pay Contracts Guarantee Security of Gas Supply? Assignment

Government responsibility for the security of gas supplies. While sovereign governments have a fundamental responsibility to ensure the security of gas supplies as part of their overall public service role with respect to national security, Pedros and Cocciolo suggest that the best interests of the United Kingdom government would be better served if it participated in collaborative efforts at the European Union (EU) level to ensure that a robust and harmonized solution is developed for the country's -- and the EU's -- future natural gas requirements. With more than 50% of current EU natural gas supplies being imported, this is a pressing issue.

In this regard, Pedros and Cocciolo conclude that, "Given the EU's common requirements and the global dimension and scope of the issues at stake, security of supply concerns should be dealt with jointly at the European level to strengthen collective negotiating capacity."

By contrast, Grigoryev reports that, "The UK has been a liberalization champion, the question becoming more pertinent after it became a net-importer of gas in 2005, whilst the continued gas price rise over the past two years has been blamed on the non-liberalized European market, where certain suppliers have been using their market power to artificially increase the price of gas in the UK."

The issue of an uncertain marketplace for companies competing in the natural gas industry is therefore directly related to issues of regulatory commitment. In this regard, Brousseau and Glachant point out that, "If a firm has an investment choice that will result in a return only at some future date, lack of commitment by the regulator to enable recovery of the investment may result in the abandonment of a cost reducing investment. Where it is possible to write some form of binding contract upheld by both parties or some third party (such as the introduction of judicial reviews in the United Kingdom) the time inconsistency problem may be mitigated."

In fact, these authorities cite that "infamous example of stranded assets has arisen as a result of regulatory reform in the UK gas industry" as indicative of this need, and add, "The incumbent monopolist signed several take-or-pay contracts which committed it to paying for gas supplies even if they were not used. As competition was introduced the incumbent lost large portions of its market, especially for industrial consumers, and found itself committed to pay for gas which it could no longer sell."

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Long-term take-or-pay contracts.

The primary purposes of take-or-pay contracts are: (a) allocation of risks (e.g., sharing and transfer of risks) and (b) to help ensure predictability. An analysis of data sets for various periods in the history of gas contracting conducted by Brousseau and Glachant found that, "Take-or-pay obligations varied with the alternative value of gas reserves, supporting an incentive interpretation over the alternative view that take-or-pay provisions served distributional or risk-sharing purposes."

2.1

Definition (nature). Unlike take-and-pay agreements that require a payment from the seller to the buyer if some product is delivered, take-or-pay agreements, in general, "refer to a contractual obligation between the purchaser of a facility's output and a company in which the purchaser agrees to make payments to the company for the good or service producible at the facility in return for maintaining the capacity to produce and deliver the good or service."

According to Culp, "A take-or-pay contract, for example, is a contract that allows a firm to purchase some amount of a commodity at a fixed price and at a variable rate over time. The only requirement is that the entire amount of the commodity must be drawn down by the end of the life of the contract, else the customer pays anyway."

Take-or-pay contracts are commonplace in the natural gas and oil industries, and Culp cites a typical example thusly: "A take-or-pay contract might call for the delivery of one million barrels of West Texas Intermediate crude over two years at the fixed purchase price of $25/barrel. The buyer can choose the schedule for delivery, which can be as flexible as the buyer's needs dictate -- ranging from all million barrels in the first month to all million in the last month to equal monthly draw downs."

The take-or-pay contract is essentially a series of long call options spread over time to allow for flexible deliveries plus a written call option on the unpurchased amount at the end of the life of the contract. Take-or-pay agreements typically stipulate that customers are committed to certain minimum monthly expenditures irrespective of their actual requirements, and these types of agreements are commonplace in the gas industry.

2.2

Elements of take-or-pay agreement. Some of the major components of gas purchase contracts include those described in Table 1 below.

Table 1

Common Elements of Gas Purchase Contracts

Element

Description

Purpose and scope of the agreement

This element sets forth what is to be accomplished pursuant to the agreement, including who will supply the gas, how it will be transported, and who will receive it upon delivery. Other comments may be included in this element, including the potential use of the natural gas, whether a sole provider is involved and so forth.

Definitions

As the term indicates, this element delineates the standard and specialized terms that are used in the contract; because of the specialized nature of the natural gas industry, this is an important element.

Terms of the agreement

This element establishes how long the agreement will be in effect and what types of conditions will serve to terminate it. Other information that may be included in this element are provisions for extending the contract beyond its original terms.

Quantity

The specific details of the agreement concerning the total quantity of natural gas being sold and delivered pursuant to the contract are included in this element. According to Turner, "If there is any take-or-pay language, this is the section for it. Take-or-pay is an agreement for the buyer to pay for gas if contracted but not taken."

Price

This element sets forth the price that will be paid for the natural gas and may include statements concerning price escalators and/or a means whereby the original price can be renegotiated.

Transportation

This element stipulates how the natural gas will be transported and who will bear the transportation costs. Some of the critical points that should be included in this element include:

1. Who is responsible for arranging for the transportation;

2. Who will pay for the transportation;

3. Whether the transportation will be on a firm or interruptible basis; and,

4. Any special conditions on either the part of the buyer or seller that could disrupt the delivery of natural gas.

Delivery point(s)

Because the delivery point or points vary from situation to situation, it is important that this information be set forth in this contract element.

Measurement and quality

This element is used to stipulate the methods, conditions and timing that will be used for measurement and quality, as well as the authority for such actions.

Billing

This element sets forth the terms for payment, including who is responsible, as well as the manner and methods by which payment will be made.

Force majeure

This final element (discussed further below) provides protections for both buyer and seller in the event unforeseen circumstances that are beyond their control prevent conformance with the provisions of the agreement.

Source: Turner 2004, pp. 592-593

2.2.1

The off-taker agreement. Pursuant to a take-or-pay contract, "The off-take purchaser makes payments for capacity whether or not the project company actually generates the good or service at the purchaser's request. The payment obligation of the buyer for the capacity component is unconditional."

2.2.2

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