How Are the Problems of Buyer in Long-Term Take or Pay Contracts in the Gas Industry Mitigated?

1. INTRODUCTION

The Gas industry has been traditionally characterised by long- term take or pay contracts

between producers and purchasers. This is due to the special nature of the gas sector.

Unlike oil, there is no global market for gas. The use of long term contracts is common in

the gas sector as it is the most convenient method of attaining this product and

guarantee ing that the gas produced will be sold. Also, the gas industry is very capital

intensive. Sellers incur very high fixed costs to produce gas. Their financiers require

some guarantee that these costs will be recovered. Rather than leaving this to the

unpredictability of markets, where the demand for gas fluctuates, sellers prefer to enter

long term take or pay contracts. By doing so, their income is assured over a considerable

period of time. The take or pay clause is an important contractual mechanism utilised by

producers to secure their investments as its basic function is to ensure that the seller is

paid a minimum amount within the framework of the long term contract.

It is important at this stage to clarify certain terms. The phrase ‘long term take or pay

contract' is commonly used for the purpose of convenience. Henceforth, this terminology

is adopted by this paper. The actual contract is the long term contract. Take or pay is not

a contract. It is a clause within the contract which, as already mentioned, serves the

function of making certain that sellers receive an agreed sum to cover their costs.

It is apparent that take or pay clauses are advantageous to sellers by reason of the fact that

they guarantee return on investments. However, these clauses may give rise to major

problems for buyers. The advent of liberalization may render the long term contracts

clauses burdensome to buyers because they are forced to uphold non competitive

obligations. Another problem of take or pay clauses is that they can promote ineffciency.

These problems raise significant questions as to whether there are mitigating

circumstances or instruments to curb the problems of take or pay contracts. The above

question constitutes the focus of this paper. The question draws its importance from the

increased relevance of the gas sector due to rising demand for gas. Take or pay is a key

element in many existin g gas contracts; they are still very popular and will continue to be

so for some time to come.1 A need therefore arises for the analysis of the attendant

problems and the solutions to them so that they may be avoided in the future.

To address the question, the paper adopts an analytical approach. The paper commences

with an overview of long term contracts in the gas industry. Take or pay clauses are also

addressed in detail. The paper then proceeds to examine the problems encountered by

buyers with regards to take or pay clauses in long term gas contracts. This is followed by

a discussion of the possible solutions to the problems. Finally, the paper concludes with

an outline of its findings and recommendations.

2. OVERVIEW OF LONG-TERM TAKE OR PAY CONTRACTS

In order to fully appreciate the problems that buyers come across in long term take or pay

contracts, it is necessary to examine the definition and structure of these agreements. It is

also important to study the gas industry in which they operate and why they are relevant

to it.

2.1. DEFINITION OF LONG-TERM TAKE OR PAY CONTRACTS

A long term