CHAPTER 6 NEGOTIATING AND DRAFTING CONTRACTS FOR THE SALE OF NATURAL GAS TO END USERS

• Jurisdiction: United States

Natural Gas Marketing and Transportation
(Sep 1991)
CHAPTER 6
NEGOTIATING AND DRAFTING CONTRACTS FOR THE SALE OF NATURAL GAS TO END USERS
John E. Dickinson
Chevron U.S.A. Inc.
Houston, Texas

I. INTRODUCTION

In recent years the Federal Energy Regulatory Commission (FERC) has made a concerted effort to create more competition among suppliers of natural gas and to eliminate or drastically reduce the traditional role of the interstate pipelines as wholesalers of natural gas.¹ These regulatory initiatives, together with market forces during a period of natural gas oversupply, have created a new role for the producer of natural gas: that of a direct seller to end users of the product. This paper will examine a number of issues raised by such direct sales and discuss the specific requirements of each of the major categories of end users.

For purposes of this paper, the term "end users" is defined rather loosely to include local distribution companies, as well as industrial facilities, utility electric generators, and cogenerators. Although local distribution companies are more akin to retailers than end users, they are certainly much further down the pipeline than producers have traditionally gone. More importantly, local distribution companies represent a major market, and the first step that many producers have taken beyond their traditional pipeline sales.

It is not the purpose of this paper to cover everything one needs to know to negotiate and draft a gas sales agreement. That task has been more than adequately undertaken by other commentators.² Instead, emphasis will be placed on the aspects of end user contracts that differ from traditional gas contracts. In addition, an attempt will be made to identify the unique needs and

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desires³ of specific end users, including local distribution companies, industrial facilities, utility electric generators, and cogenerators. Finally, a number of potential pitfalls that might be encountered in end user sales will be explored and some suggestions will be made as to how those problems can be avoided or contractually mitigated.

II. SIMILARITIES AND DIFFERENCES BETWEEN END USER CONTRACTS AND PIPELINE CONTRACTS

Depending upon the size and sophistication of the particular end user involved, the seller may or may not be presented with a standard form contract. If a standard form is tendered, it is likely to contain many familiar provisions. For example, there will be provisions addressing contract quantity, delivery points, price, term, measurement, payment, force majeure, warranty of title, notices, and audit rights. These are all issues that must be addressed in end user contracts, just as they have always been addressed in the more traditional wellhead contracts with pipelines. In many cases, the substance of these provisions will also be very similar. The most substantial deviations will occur in the quantity, price, and term provisions.⁴ The specifics of these provisions will be discussed in more detail below, where the unique requirements of each type of end user are explored.

In addition to the familiar provisions that have always occurred in some form or another in gas contracts, the seller is also likely to encounter some new and possibly surprising provisions covering such matters as transportation arrangements and responsibilities, nominations and scheduling, pipeline imbalance penalties, demand charges, deficiency charges, and/or liquidated damages.

The producer dealing with end users for the first time is often surprised by the diversity which exists within the general category of end users. This diversity may manifest itself in widely varying degrees of sophistication, in differing contracting objectives, and in negotiating styles. The fact that end users are relatively new players in the gas purchasing game does not necessarily mean that they are unskilled or unsophisticated. On the contrary, their lack of background in historical contracting practices often results in their use of highly innovative tactics,

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such as competitive bidding procedures and matrix analysis of competing offers. While end users may not always fully understand the needs, concerns, and operational parameters driving producers, they certainly understand their own needs and will seek to shape contracts that address those concerns.

Another important aspect of selling to end users is their geographical diversity and their relatively small supply requirements when compared to pipeline purchasers. Producers accustomed to selling to pipelines will quickly find that a significantly larger gas sales staff is required to develop and administer a portfolio of end use sales. The end use customers are widely spread geographically, and it will usually be necessary to negotiate a number of contracts with different buyers to replace a single long-term large volume pipeline contract. Administration of end use contracts also demands more staffing to handle monthly and daily scheduling, reconciliation of delivery imbalances, and resolution of measurement and billing disputes. Where such matters were previously addressed between a producer and a single pipeline, they now involve the producer's representatives, one or more pipelines, and the representatives of the various end users.

One issue in particular was virtually nonexistent in traditional wellhead sales to pipelines but becomes critical in end user contracts. That issue is transportation. Every negotiation with an end user will invariably include a discussion of the type of transportation to be utilized, the receipt and delivery points, the responsibility for arranging for and paying for transportation, and a delineation of the parties' respective duties to make and confirm transportation nominations and to control and adjust daily deliveries. In many cases the end user will already have transportation arrangements in place, and the producer must determine whether those transportation arrangements are consistent with the producer's production facilities.

Transportation, especially interstate transportation, may occur under either an interruptible or a firm transportation agreement.⁵ It is important that the parties agree at the time of contracting as to which type of transportation will be utilized,

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so that the parties' sale and purchase obligations can be addressed in the contract in a manner consistent with the transportation arrangements. Thus, it would make little sense for a producer to assume a firm obligation to deliver gas utilizing interruptible transportation. By the same token, firm transportation, which requires payment of a demand charge regardless of usage, may not be the most efficient way to move gas purchased under interruptible contracts.

While transportation is usually addressed in a separate section of the contract, the effect of the force majeure provision on transportation obligations should not be overlooked. Many force majeure provisions include within the definition of force majeure events such things as "loss of transportation" or "failure of any third party to provide necessary transportation." Where such language is included in the force majeure clause, it is at least arguable that curtailment of interruptible transportation gives rise to a force majeure defense, even though such curtailments are neither unusual nor unanticipated. If the parties intend to enter into an otherwise firm contract for the purchase and sale of gas, it may be appropriate to include in the force majeure clause specific language negating failure of interruptible transportation as a force majeure event.⁶

Two other matters normally dealt with in considerable detail in the traditional pipeline contracts will also be present in contracts with end users, albeit in a considerably abbreviated form. In the past, measurement and quality provisions have been the subject of detailed negotiations between producers and pipelines, and the resulting agreements have been spelled out in lengthy and often complex contract provisions. In the case of end user contracts, however, it is becoming common for those matters to be dealt with rather summarily by reference to the tariff provisions of the pipeline receiving the gas at the specified delivery point(s). Consequently, the seller's obligation with respect to quality is normally satisfied if the seller delivers gas which meets the quality specifications of the first pipeline downstream of the delivery point. Responsibility for measurement of the gas delivered under the contract is also normally assigned

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to the first pipeline downstream of the delivery point, and the detailed provisions of that pipeline's tariff with respect to measurement of gas are usually incorporated by reference in the end user contract.⁷

Finally, the effect on the end user contract of pipeline fuel and lost gas deductions should not be overlooked at the negotiating stage. Most pipeline tariffs provide for an in-kind deduction and retention of gas by the pipeline to cover the cost of compressor fuel and the small quantities of gas lost during normal operations of the pipeline. This in-kind deduction will often be in the range of one and a half to three percent of the gas measured at the delivery point. Consequently, if the delivery point in the end user contract is in the field or at a pipeline pooling point, the end user which desires to receive 100 MMBtu of gas at its facility will have to nominate and pay for at the delivery point 100 MMBtu's plus the amount that will be deducted by the pipeline for fuel and lost gas.

III. SALES TO LOCAL DISTRIBUTION COMPANIES

A producer's direct sales to local distribution companies (or LDCs) will generally fall into one of two categories: either spot sales or long term sales. Spot sales are generally interruptible by either party without liability and usually have a term of from 30 to 90 days, although they are often made and...