Oil & Gas: No damages awarded for breach of capacity obligation in take or pay arrangement

England and Wales

In British Gas Trading Limited v Shell UK Limited & Anor [2020] EWCA Civ 2349, the Court of Appeal considered the ‘ramp down’ provisions of two ‘take or pay’ long term gas sales agreements. Although the sellers were in breach of contract for not providing the relevant capacity notices to the buyer with the effect of ramping down ‘take or pay’ quantities (which would have allowed the buyer to escape expensively priced long-term gas), the buyer was still under an obligation to buy the gas and the breach did not result in a compensable loss. The decision serves as a reminder as to the criticality of careful drafting of provisions linked to ‘take or pay’ quantities.

Background

The Principal Agreements

Two long term agreements for the sale of gas from reservoirs in the North Sea on materially identical terms were entered into between Shell UK Limited and Esso Exploration & Production UK Limited (the “Sellers”), and British Gas Trading Limited (“British Gas”), as buyer, in December 1988 (the “Principal Agreements”).

The Principal Agreements were ‘take or pay’ agreements, providing for a minimum amount of gas that British Gas must either take delivery of, or pay for, every year. The quantity of gas which British Gas was required to take depended on the Total Reservoirs Daily Quantity (“TRDQ”). The TRDQ changed over the life of the contract with three distinct periods (starting with the ‘Run-In Period’, it increased during the ‘Build-Up Period’ and was followed by the ‘Plateau Period’). After expiry of the ‘Plateau Period’, the TRDQ was constant until reduced pursuant to variation notices which the Sellers had a right to serve if they considered that they would be unable to maintain the TRDQ during a contract year. The TRDQ could not be increased.

Pursuant to clause 6.4(1) the Sellers were required to maintain the capacity to deliver gas from the reservoirs at the rate of 130% of the TRDQ. The wording of clause 6.4(1) stated:

Subject to clause 6.8 with effect from the Start Date the Seller shall provide and maintain a capacity (herein referred to as the ‘Delivery Capacity’) to deliver Natural Gas from the Reservoirs on each Day at a rate of not less than the DCQ applicable for such Day multiplied by one hundred and thirty (130) percent and BG shall have the right on any and every Day (subject as herein provided) to require delivery of Natural Gas at rates up to the appropriate Delivery Capacity determined hereunder notwithstanding that the aggregate of such daily requirements made in respect of any Contract Year exceed the ACQ…

The ‘DCQ’ was each Sellers’s proportion of the TRDQ. Each Seller's Proportion was 50% and each Seller's DCQ was therefore 50% of the TRDQ.

Shell Bacton Sub-Terminal Allocation Commingling and Attribution Agreement

The Sellers, British Gas, and producers from other reservoirs were parties to a Shell Bacton Sub-Terminal Allocation Commingling and Attribution Agreement dated 30 September 1997 (the “STACA”).

The STACA required:

  1. gas produced from a number of different reservoirs to be commingled and processed at a Shell sub-terminal, and for processed gas to then be re-delivered to producers on a pro rata basis for delivery to British Gas and producers from other reservoirs; and

  2. gas to be lent and borrowed between ‘User Groups’ such that the Sellers were required to lend gas produced from the Sole Pit Reservoirs to producers from other reservoirs to ensure that if there was shortfall in one reservoir, it could be compensated by another. The gas lent had to be repaid to the Sellers as soon as reasonably practicable.

In this case, the Sellers had accumulated a large amount of gas which had been lent to other User Groups. Accordingly, there was a balance of 72,811 terajoules of gas owed by the User Groups to the Sellers under the STACA. The Sellers were able to supply British Gas using these reserves of ‘repayment’ gas.

The Sellers served several variation notices reducing the TRDQ between 2000 and 2009 as the production volumes of the Reservoirs declined.

The dispute

British Gas did not complain of any failure by the Sellers to deliver the amounts of gas properly nominated for delivery under the Principal Agreements. It argued that the Sellers were in breach of the obligation under clause 6.4(1) of the Principal Agreements to provide and maintain a capacity to deliver gas from the Reservoirs at a specified rate. British Gas contended that, in order to comply with that obligation in circumstances where production volumes were in decline, the Sellers ought to have served additional variation notices to reduce the TRDQ. In turn, this would have resulted in a reduction of the volume that British Gas was obliged to ‘take or pay’. If such reductions had occurred, British Gas would have bought other gas in the market at a cheaper price.

Commercial Court Decision

At first instance Lionel Persey QC, sitting as Deputy High Court Judge, dismissed British Gas’s claim that clause 6.4(1) of the Principal Agreements required the Sellers to deliver the agreed capacity from the Reservoirs only; and that a term should be implied that the Sellers’ right to issue variation notices to reduce the TRDQ should be exercised honestly and in good faith. He held that to determine whether the Sellers maintained the necessary capacity, it was permissible to take account of the ‘repayment’ gas from other reservoirs owed to the Sellers by other User Groups. Accordingly, the Sellers were found not to be in breach of their obligations.

The issue of damages for breach of the capacity obligation under clause 6.4(1) did not arise at first instance due to the conclusion on liability. Yet, the judge found that if it had arisen, damages would be assessed on the basis that the variation notices would have reduced the amount of gas that British Gas was required to take.

British Gas appealed the decision on the construction of the obligation under clause 6.4(1) of the Principal Agreements, and the Sellers cross-appealed on the issue of assessment of damages.

Court of Appeal Decision

The Court of Appeal favoured British Gas’ submissions concerning the construction of clause 6.4(1) and allowed the appeal. However, it decided that the breach did not result in any loss or damage. It found that:

  1. The obligation owed under clause 6.4(1) was a capacity obligation to supply gas from the Reservoirs, not a delivery obligation.

  2. The fact that the TRDQ changes over the life of the contract suggested that the TRDQ and thus the Delivery Capacity were expected to be based upon the physical production capacity of the Reservoirs.

  3. Clause 4.1 of the Principal Agreements says nothing about the availability to the Sellers of gas from other reservoirs. That was a strong indication that gas from other sources was not intended to be taken into account.

As a result, absent sufficient variation notices, the Sellers were in breach of their clause 6.4(1) obligation to ensure the delivery capacity was not less than 130% of the daily contract quantities.

Damages

However, the Court of Appeal allowed the Sellers’ cross-appeal on the assessment of damages. It disagreed with the judge at first instance that the Sellers were under an obligation to track the decline of the reservoirs by the service of variation notices.

Lord Justice Males, giving the leading judgment concluded that damages for breach of contract must be assessed on the basis that the Sellers had performed their obligation. That is not the same as saying that damages should be assessed as if the Sellers had taken steps to avoid being in breach of contract in the first place. The breach here was the failure to maintain Delivery Capacity of 130% of the TRDQ. It was not the failure to serve a variation notice. The Sellers were not under an obligation to serve a variation notice each and every time Delivery Capacity may not be 130% of the TRDQ.

Damages could not be assessed as if the Sellers were under an obligation to serve a variation notice: they were not.

The relevant counterfactual for the purpose of assessing damages was that the Sellers would have maintained a Delivery Capacity of 130% of the TRDQ per day. On this basis, British Gas had suffered no loss. If the Sellers had complied with their obligations they would have delivered the same quantity of gas at the same price.

Commentary

The economic facts underlying the case are that the Principal Agreements clearly created a price above market, such that British Gas was keen to reduce its exposure to ‘take or pay’ quantities. The Principal Agreements also clearly envisaged that the Sellers would have started to reduce these quantities. However, on the Court of Appeal’s construction, the agreements failed to oblige the Sellers to reduce quantities. The Principal Agreements merely gave the Sellers the opportunity to do so to avoid a breach of contract of their obligations as to maintaining sufficient capacity.

This case highlights the need for buyers to carefully consider the drafting of provisions linked to take or pay volumes, such as any ramp down phase of the field in a take or pay agreement. Unless a seller is obliged to issue a notice, it may not do so if it can source gas from elsewhere to satisfy volumes without contractual breach.

The Principal Agreements were typical life of field contracts. The way that the Principal Agreements were drafted meant that the Sellers were under no obligation to serve a variation notice to reduce the TRDQ if they were unable to comply with their obligations to supply 130% of the TRDQ. Accordingly, failure to serve a variation notice did not amount to a breach of the Principal Agreements and damages could not be assessed as if the Sellers were required to serve such a variation notice. British Gas would only have suffered damage if there had been an obligation to issue a variation notice.

Lady Justice Andrews and Lord Justice Peter Jackson, both concurring with Lord Justice Males, made an observation that this contract contained a careful internal tension linking performance on both sides with production capacity. The Sellers’ ‘capacity obligation’ required them to maintain the physical capacity to meet the prevailing contract quantities. The breach of clause 4.1 of the Principal Agreements can occur with impunity, provided that the Sellers deliver enough equivalent gas to meet British Gas’ nominations. British Gas is locked into taking and paying for gas that it does not want on grounds of price. This outcome effectively short-circuited the protection contained in the default provisions of the Principal Agreements, which provided a detailed regime for British Gas to be entitled to cheaper gas later on, should the Sellers fail to deliver the nominated amount of gas on time.

Judges: Males LJ; Andrews LJ; Peter Jackson LJ