Traps of trading in oil: how safe are new contracts?

Feature | 24 August 2017
Oil_Legal_Regulatory

As the oil market adjusts to new price points, traders are presented with many opportunities to do fresh business, but how safe are new contracts? Marko Kraljevic and Hatty Sumption set out the legal traps

The legal landscape for oil traders continues to present significant challenges for the unwary. Although the oil price has recovered from previous lows and is now around US$54 per barrel, the scope for fluctuation remains significant, though industry participants are not predicting an imminent return to levels much above US$60-70 per barrel.

Reports suggest shale gas production in the US that had slowed or shut down when faced with the low prices seen in 2016 are starting up again. The prospect of deregulation in a Trump-led US also suggests that production might increase. In addition, levels of oil in storage remain high, adding a further level of complexity as producers continue to struggle with a lack of investment that has made a return to risky prepayment deals more likely. The slowdown in demand from China also seems set to continue and may well feed into an increase in counterparty risk.

Another factor that continues to play into a difficult market is the ripple effect associated with sanctions, whereby the fear of being in breach has a continuing impact even when the overall scope of sanctions is reduced. In the case of Iran, the inward investment in infrastructure upgrades needed to deliver significant quantities of oil to market has not yet materialised. Although Iran is reportedly close to announcing the full terms and conditions of a new oil and investment contract that is intended to replace previous buyback oil deals, the experience of recent sanctions and uncertainty surrounding the future may create difficulties.  

Non-performance risks

In an uncertain market, deals can rapidly become less attractive to a particular party, especially where we see continued oil price volatility as opposed to a continuing upward trend. Parties facing liquidity issues or who are committed to contracts that are not as profitable as they were expected to be are increasingly alert for any opportunities to avoid performance or escape from their obligations. In such cases we tend to see arguments from counterparties challenging the existence or validity of the contract, or seeking to reject the goods and terminate the contract.

Given the commercial pressure under which traders operate, it is not uncommon for situations to arise where there is a lack of clarity as to when a contract has actually been formed and what its terms are. The result is that each side can end up with a different understanding of what was agreed, or how a court or arbitral tribunal would go about deciding what the terms meant. In the good times, when both parties have an interest in making a deal work, such uncertainty is much less likely to be exposed or relied upon. However, as soon as one party runs into financial difficulty and seeks to escape from the deal, such issues become critical.

In addition, it is not uncommon for traders to misunderstand the extent to which either they or their counterparty may be entitled to reject goods. It is not as easy as many think but is nevertheless not an uncommon problem to arise.

Storage risks

Difficult and uncertain trading conditions will often result in disputes arising out of insolvencies. Experience indicates that insolvencies can often have a fraud dimension and that oil storage can be a particular area of fraud exposure in an oil trading context. Such problems can become increasingly complex where floating storage is utilised. Many organisations risk exposure as a result of poor practices and inadequate controls, which developed during buoyant times for the market. If liquidity continues to be an issue, those practices are unlikely to guard against the impact of insolvencies and an increase in instances of fraud.

Although they have been reducing recently, oil storage levels remain very high even though recent changes in the market structure have seen movements away from contango towards backwardation. Market estimates suggest that over 50 oil tankers are currently being used for storage and although this number is down from the estimated total of 75 vessels earlier in the year, this remains a significant feature of the current market.

A key problem when things go wrong is a lack of accurate monitoring of oil stocks in storage and clarity in the method of storage adopted. Poor facility management can result in theft, misappropriation or misallocation. While it is safest to have clear segregation of the oil, this is not usually practical and in reality most stored oil is comingled or even blended. Where an insolvency of the storage facility occurs, or of a counterparty which makes use of such storage, this can be a significant complicating factor and a major feature of the ensuing litigation is often the resolution of competing proprietary claims to cargoes that are recovered. Such disputes tend to arise between innocent (and solvent) parties affected by fraud and/or insolvency - for example disputes over title to goods where the only way for multiple parties to recover their losses is by establishing ownership over the same asset. Corruption is also an area of concern and may result in greater difficulties in enforcement even when litigation has been successful.

What can traders do?

A key message for traders would be to tighten up their practices in relation to contracts and, in particular, to consider the following:  

  • Contract formation: don't stop half way. Follow up after the recap and get it all in writing. Many disputes arise where parties think that the contract is the last wording that they sent across, whereas in reality it is essential to be able to demonstrate agreement in order for the other side to be bound. In certain instances the law can fill gaps in an agreement where appropriate, but achieving this can be an expensive and unpredictable process, so why leave it to chance?

  • Focus on rights to reject: traders should think carefully about whether they intend the counterparty to be able to reject for a breach of product specification and to reflect this in the contract. It's not as simple as many think and the mechanism, together with the relevant specification itself, should be clear.

  • Keep an eye on the counterparty's financial stability - are they sound? Can security be obtained? Are there appropriate triggers for cancellation in the contract to avoid having to deliver to a party that has or is about to become insolvent? Even if the contract does not provide a mechanism for cancellation, or where the exposure has already arisen, there may still be advantages to be gained commercially or under relevant insolvency law by acting quickly and seeking to restricting any exposure at an early stage.  

Where storage is an issue it is advisable to gain a clear understanding of the applicable law of the country in which the facility is located at an early stage - something that may not always be straightforward in the case of floating storage. Security or proprietary interests in the goods should be protected under local law wherever possible and this should be reflected where necessary in the storage arrangements. Even then, it is very much a matter of risk management given that some jurisdictions are more reliable than others. Care should also be taken concerning insurance arrangements. The terms of cover require careful scrutiny, with particular regard to whether all the anticipated risks are covered, including the effect of local law upon interpretation of the policy.

Tighten up outcomes

Even in difficult market conditions, experienced players in the oil market will find ways to operate effectively and even to prosper. The FT recently reported1 that the top five independent oil traders, including some of the world's largest independent commodity houses, have increased their oil trading volumes by more than 65% during the recent oil price slump. While opportunities undoubtedly exist for successful trading even in times of market uncertainty, a number of legal traps can await the experienced operator and unwary alike.  

Counterparty risk, insolvency and fraud can result in significant exposure and represent serious risks. However, as we have seen, there are a number of practical steps that can be taken to mitigate and manage such risks. In particular, the tightening up of practices in relation to the conclusion of contracts can significantly improve the position when faced with non-performance and the potential risks of oil storage as part of a trading position must be carefully understood and appropriately managed.

Hatty Sumption and Marko Kraljevic are partners at Clyde & Co.

Box-out 1

Update on the blockade against Qatar

On June 23rd Qatar was issued with a 13 point ultimatum by the four principal Arab states imposing the diplomatic and trade restrictions. The list of demands included stipulations that Doha drastically scale back cooperation with Iran; align itself with the other Gulf and Arab countries militarily, politically, socially and economically, as well as on economic matters; remove Turkish troops from Qatar's soil; end contact with groups such as the Muslim Brotherhood; submit to monthly external compliance checks; and close the broadcaster Al Jazeera, among others.

Qatar was given 10 days to comply with the demands or face unspecified consequences. It failed to comply with the demands within the given time frame so the restrictions remain in place. However, at the time of writing (14/07/17) news emerged that the original 13 demands could now be reduced, in particular the request to close Al Jazeera. Instead, the Saudi-led bloc will demand a "fundamental change and restructuring" of the Arabic-language news channel, while the English arm could remain largely unchanged.

It has been reported that the likely next stage of sanctions will be capital and credit controls. Economists in the region are saying this is well under way, pointing to the drying up of liquidity and start of capital flight. This has the potential to lead to the end of the six-member Gulf Cooperation Council, which would of course have a significant impact on businesses operating in the region.

Performance of contracts

A wide variety of contracts might be affected by the restrictions imposed, whether those contracts are for the sale or supply of goods, the provision of services or, the carriage of goods. Parties may find that the performance of a contract has become more difficult, expensive or potentially impossible because of the restrictions imposed. There will be questions as to whether contracts are able to be suspended or terminated because of a force majeure event, whether they have been frustrated, or whether there are exceptions in a contract to allow performance to be carried out in an different manner, as well as the inevitable disputes over who pays for delays or increased costs that have resulted from the disruption.

For contractual arrangements that are currently being negotiated, businesses may wish to revisit obligations regarding supply, transportation, payment and force majeure to improve certainty and flexibility in those arrangements and to ensure that the terms of those contracts can support the unfolding situation.

Insurance

Recent developments are likely to have a significant effect on a variety of current and future insurance covers. It can be foreseen there will be questions regarding the application of insurance policies that typically deal with such risks, including trade credit and political risk policies. However, if matters are not resolved quickly, it can be expected that the current situation will have a significant and broad impact on a variety of other policies.

Until the current issues are resolved, re/insurers, insureds and brokers would be well advised to consider the impact of ongoing developments on, for example, insured values, indemnity periods, the application of exclusions, and other practical issues such as the ability of nominated loss adjustors to easily visit Qatar. Notices that may be required where the insured risk has changed will also need to be considered. The broader re/insurance industry will therefore need to continue monitoring developments to ensure they are fully aware of the potential impact on their rights and obligations under existing and future insurance covers.

The situation is still rapidly developing. The US' top diplomat, Rex Tillerson, visited the Kingdom of Saudi Arabia and Qatar on July 12th and 13th to try and broker a deal. He did not succeed and now it remains to be seen how the situation will develop.

References: 

Reference

  1. See FT article 'Oil trading surge strengthens grip of big commodity houses':
    http://on.ft.com/2v9TpYy

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