Australia: In hard times will take-or-pay contracts in the Australian coal industry be challenged?

High Court decisions in the UK and Australia have called into question the enforceability of take-or-pay contracts. This could be a big deal in Australia's resources sector where many miners are locked into long term contracts and are losing money hand over foot.

During Australia's mining boom, long term take-or-pay arrangements1 underpinned many energy and resources projects. For miners, the contracts guaranteed them minimum streams of revenue and protected them from any downward price fluctuations.

Project financiers frequently required miners to enter take-or-pay agreements with customers to provide certainty as to servicing of the debt they provided.

In the coal sector take-or-pay arrangements have been more common in port and rail contracts and supply contracts for mining equipment and critical supplies like explosives. These worked to guarantee minimum demand levels for rail or port facilities or equipment over long periods.

AFTER THE BOOM LOSSES MOUNT UNDER TAKE-OR-PAY ARRANGEMENTS

Demand for Australian coal has been greatly impacted as Chinese and Indian growth have slowed and exports of cheap coal from the US has surged (a result of the shale gas revolution in the US with shale gas becoming a real alternative to coal in the US domestic market).

Plummeting coal prices have left miners and their customers exposed to obligations to take or pay for products and commitments they may not need.

Some Australian miners are producing coal at costs higher than the market price. Others are being forced to declare contingent liabilities on their balance sheets where they have obligations to pay for committed but unused port and rail capacities. Under those contracts the coal miners have to pay the rail or port operators the agreed minimum amount for rail or port access even if they require less (or no access).

In theory coal miners could cut production in an effort to drive up prices by causing a shortage. However, take-or-pay arrangements mean that cutting production would not significantly reduce costs, as coal miners are contractually obliged to pay irrespective of their production level.

A recent report by Wood Mackenzie2 confirms that take-or-pay contracts are leading miners to continue production, despite the losses. In fact, coal production in 2013 is likely to be at nearly the same levels as the previous year. In total, around 32,000,000 tonnes of coal is expected to be produced at a loss this year.

To make matters worse, a number of customers under take-or-pay coal supply contracts are purchasing the minimum contract amounts of coal and disposing of their surplus needs on the spot market. This is putting further pressure on the market price of coal.

ENFORCEABILITY OF TAKE-OR-PAY ARRANGEMENTS

However, two recent decisions, one by the UK High Court in E-Nik Ltd v Department for Communities and Local Government [2012] EWHC 3027 (Comm) and one by the Australian High Court in Andrews v ANZ (2012) 290 ALR 595, raise issues around the enforceability of take-or-pay contracts3.

In short, take-or-pay clauses may in certain cases constitute penalties and therefore be unenforceable. The question whether a take-or-pay provision is a penalty is one of characterisation, to be determined as a matter of substance, taking into account all the circumstances4.

The implications of Andrews have been well canvassed, including in two articles by Corrs Chambers Westgarth: Andrews v ANZ - Do all contracts need to be rethought? and What do productivity, performance contracts and a bank fee dispute have in common?.

As take-or-pay obligations continue to cause difficulty in the coal mining sector and more broadly, Australian companies subject to these obligations may follow the lead of their British counterparts (such as in E-Nik) and seek to challenge their enforceability.

Such challenges could have significant implications not only for the parties to the take-or-pay contracts concerned, but also their financiers. In the current economic climate, there is potential for parties to litigate these types of contracts as was seen in the similar downturns that affected the international oil and gas markets in the early 80s.

The particular take-or-pay provision in each individual contract will need to be judged in the context of the particular circumstances surrounding it. However, as a general proposition, the take-or-pay provisions typically found in port and rail contracts in the Australian coal sector are commercially negotiated and justifiable arrangements, and seem likely to withstand challenge and be found to be valid and enforceable.

Purchasers may also be considering approaching their suppliers to renegotiate take-or-pay arrangements. That may serve both parties' interests. However, purchasers need to be careful how they approach suppliers in such negotiations so as to avoid any potential claims of anticipatory breach of contract.

Footnotes

1A take-or-pay contract is an arrangement between a customer and supplier in which the price of a good or service is fixed for a specified minimum quantity of that good or service. That price is payable by the customer, irrespective of whether the good or service is taken by the customer. Sometimes, but not always, customers have make-up rights, so that any good or service a customer doesn't take in one period can be rolled over for free into the next period.

2"Take-or-Pay Contracts Continue to Incentivise Australian Coal Producers Despite Potential Negative Cash Margins" Wood Mackenzie, 16 July 2012. Accessible from http://www.woodmacresearch.com/cgi-bin/wmprod/portal/corp/corpPressDetail.jsp?oid=11413730.

3These two cases were also cited in a recent Victorian decision Cedar Meats P/L v Five Star Lamb P/L [2013] VSC 164

4O'Dea v Allstates Leasing System (WA) Pty Ltd (1983) 152 CLR 359, 141-2, 400.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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