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Law360 (April 21, 2020, 5:04 PM EDT) --
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| Nicolas Borda |
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| Ramy Morad |
As the world grapples with these lockdowns, the global slowdown in activity has led to an economic downturn affecting participants in all industries, prompting countries like the U.S. and Canada to develop economic stimulus plans to help support citizens and businesses. Mexico, moreover, may tap into the $7 billion remaining in its stabilization fund as a means of coping with the economic challenges brought on by the pandemic.
Liquefied natural gas markets, both domestic and international, have also been affected and are being rattled by both supply-side and demand-side shocks. For example, India, a large importer of LNG, imposed a 3-week nationwide shutdown on its 1.3 billion citizens. This shutdown has led to reductions in the consumption of natural gas across the country, causing LNG importers to issue force majeure notices to suppliers.
Moreover, the shutdown of manufacturing facilities in other parts of the world caused by the COVID-19 pandemic has potentially provided an unexpected reason for off-takers to not perform pursuant to their LNG sale and purchase agreements, which generally include epidemics as a force majeure event, provided that commercially reasonable efforts to overcome or mitigate the force majeure event were taken.
These force majeure issuances only contribute additional pressure to gas prices that are already low because of a gas market that is oversaturated in supply. In addition, the Saudi Arabia-Russia price war has further sent shockwaves into the oil and gas industry, and has led to a more than 50% drop in U.S. crude oil prices since the beginning of March, which is also negatively affecting the price of natural gas.
This "imperfect storm" is affecting all participants within the energy space sector, including the developers of LNG projects and other LNG market participants. While an imbalance in the global LNG market existed before the outbreak of the coronavirus — mild winters in Europe and Asia, increased inventories of gas in Europe, and a trade war between the United States and China all playing a role — the economic downturn resulting from these shockwaves is exacerbating challenges for proposed LNG projects across Canada, the U.S. and Mexico.
Challenges for Proposed LNG Projects in North America
Canada
Canada is no stranger to LNG projects gone awry due to unfavorable market conditions. In 2017, Malaysia's Petronas quit from the proposed Pacific NorthWest LNG project because of a low LNG price environment.
Also, LNG Canada — a joint-venture project between Royal Dutch Shell PL, Petronas, Mitsubishi Corp. and Kogas Gas Corp., and the single largest private sector investment project in Canadian history — was supposed to reach a final investment decision in 2016, but was also delayed due to a poor price environment attributed to increased growing capacity from Russia and Australia.
Canada is home to approximately 20 proposed LNG export projects, most of which are located on Canada's West Coast in British Columbia. The COVID-19 pandemic is already impacting a few of these proposed projects.
In March, Pacific Oil & Gas Ltd., the developer of the Woodfibre LNG project in Squamish, B.C., announced that it was delaying construction of the project until summer 2021; construction was initially set to begin this summer. The delay is attributable, in large part, to COVID-19, as the Asian fabrication yard manufacturing the project's components was closed to prevent the spread of the coronavirus.
LNG Canada announced that it was letting go of 750 of its workers as a preventative measure against the COVID-19 pandemic. Meanwhile, across the country in Nova Scotia, Singapore-based LNG Ltd. is having difficulty securing long-term off-take agreements for its Bear Head LNG facility, thanks to an oversupply of gas in the market.
United States
LNG in the U.S. is also grappling with its own host of issues in light of the COVID-19 pandemic. In 2019, 10 LNG projects in the U.S. were set to be approved, but were ultimately pushed into 2020 as a result of an oversupply of natural gas and the tariff disputes between the U.S. in China, the fastest-growing market for LNG.
The additional complexities brought on by the COVID-19 pandemic further jeopardize the viability of some of these projects. Indeed, with respect to certain of these projects, the coronavirus's effects are already materializing.
The ripple effects caused by COVID-19 on U.S. LNG are being felt across the country. Louisiana projects, including the Lake Charles LNG project, the Driftwood LNG project and the Magnolia LNG project, are being particularly affected. The Lake Charles LNG project — initially structured as a 50/50 joint venture between Energy Transfer LP and Shell — was dealt a shocking blow when Shell announced in March that it was pulling out of its investment in the project, citing unfavorable market conditions.
The decision to pull out of the project came on the heels of its announcement a week prior that it would reduce its 2020 capital expenditures by $5 billion and its 2020 operational expenses by $3-4 billion, because of the collapse in oil prices caused by the coronavirus pandemic and the Saudi Arabia-Russia oil price war. Although Energy Transfer remains committed to pursuing the project, doing so may require a reduction in the size of the project from three trains to two trains.
Meanwhile, LNG Ltd., which is developing the Magnolia LNG Terminal, also located in Lake Charles, is facing the same off-take challenges as with its Bear Head LNG facility in Nova Scotia. In nearby Calcasieu Parish, the $30 billion Driftwood LNG project proposed by Tellurian Inc. is also facing market headwinds, causing the company to reshuffle its corporate executives and reduce its workforce by 40% in order to maintain the viability of the project.
Further complicating development of the Driftwood LNG project, Indian importer Petronet LNG Ltd. has delayed until May its final decision on its commitment to off-take 5 million metric tons of LNG per year. The challenges, though, are not specific to Louisiana LNG projects.
In neighboring Texas, for instance, Cheniere Energy Inc. — the largest LNG company in the United States — announced that a customer of its Corpus Christi LNG facility canceled its cargo of LNG for the month of April. This is in addition to another cargo cancellation from its Sabine Pass LNG project in Louisiana.
February brought a wave of approvals for new LNG export terminals to be located in Texas, including Exelon Corp.'s Annova LNG terminal, NextDecade Corp.'s Rio Grande LNG and the Texas LNG export terminals — all of which will be constructed in Brownsville — as well as the expansion of Cheniere Energy's already existing Corpus Christi LNG export terminal.
Given the current climate, final investment decisions for some of these projects may have to be delayed until more favorable market conditions return, whenever that may be.
Mexico
Most oil and gas resources in Mexico remain undeveloped, and there is a large number of gas fields that are not economically viable. So Mexico will continue to rely on the import of natural gas from the U.S., which is the cheapest market in the world. Currently, Mexico has significantly reduced its natural gas imports from the U.S. due to a ramp-down of Mexican manufacturing facilities.
Nevertheless, Mexico has already significantly increased its capacity for imports of natural gas from the U.S., with the TC Energy Corp. and IEnova subsea pipeline from South Texas to Tuxpan, Veracruz, helping to alleviate the natural gas shortage in the Yucutan Peninsula and supply industry, hotels and power plants. Engie Resources is also contributing to this natural gas supply shortfall by building additional pipeline infrastructure to help with this problem.
According to the U.S. Energy Information Administration, Mexico imported 1,864,994 million cubic feet in 2019 of natural gas at an average price of $2.57 per thousand cubic feet, and 144,476 million cubic feet of LNG at an average of $4.57 per thousand cubic feet.
China will play an important role in the post-COVID-19 recovery of Mexico and Latin America for many reasons, including the purchase of distressed assets, securing natural resources, creating markets for their exports (i.e., wind turbines and solar panels), gaining a geographic position to sell into the North America market, and taking advantage of the access to very low cost natural gas prices.
In the past few days, Moody's Corp. and Fitch Ratings Ltd., respectively, lowered their credit ratings for Mexico to Baa1 and BBB-. In addition, Moody's and Fitch lowered their respective credit ratings for Mexico's state-owned oil company Pemex to Ba2 and BB- (junk status), due to continued depreciation of its individual credit profile and the economic downturn in the oil and gas industry. On April 21, the Mexican government gave Pemex a $2.5 billion tax incentive.
Opportunities
Notwithstanding the gloom overhanging the LNG industry, there are some bright spots that may present opportunities for LNG market participants. In the U.S., for example, a proposed rule by the U.S. Pipeline and Hazardous Materials Safety Administration may pave the way for the shipment of LNG in bulk via railroad, without the need for companies to obtain special permits to do so.
Petitioners in favor of the proposed rule suggest that there is a commercial interest in transporting LNG domestically by rail tank car, and internationally from the U.S. to Mexico. More significantly, advocates of the proposed rule suggest that some railroads are actively exploring the use of LNG as a locomotive fuel, thereby requiring supply of LNG along their networks. This deregulation may serve to benefit the U.S. LNG industry by opening up markets not previously available, which in turn, would help drive demand.
In Mexico, the Federal Electricity Commission — the country's national power utility — recently launched a bidding process to purchase natural gas to be supplied in Baja California. Although there are many parties interested in providing a short or long term solution to the natural gas shortage in the Baja area, timing, volume, permits and environmental issues will play important roles in the decision-making process.
Moreover, issues such as place of arbitration, administrative rescission, credit risk, guarantees, change of law provisions and other provisions will be key in the analysis by potential suppliers.
Some of the current developments in the Mexican LNG market include the planned LNG project in Puerto Libertad, Sonora, in the Sea of Cortes, and the existing Ensenada LNG terminal. Mexico Pacific Limited LLC has awarded a front-end engineering design contract to Technip USA Inc. for its planned LNG export project in Puerto Libertad.
The project has the approval to export 12 million metric tons per year from the U.S. Sempra Energy, through its affiliates, is converting its Energia Costa Azul LNG facility from regasification to liquefaction, and is in negotiations with Total SA, Mitsui & Co. Ltd. and Tokyo Gas Co. Ltd. to take capacity in this LNG export terminal.
Development banks will play a prominent role in financing floating storage regasification units, liquefaction terminals, regasification terminals and other infrastructure related to LNG projects due to the mandate from governments to foster economic recovery. For example, in the U.S., the U.S. Department of Energy is playing an important role in developing projects to export LNG from the U.S.
Conclusions
Whether attributable to force majeure, frustration, impossibility, rebus sic stantibus, material adverse impact or any other legal theory, off-takers may have a justification not to purchase LNG from different sources under the agreed conditions. Subject to the facts in each case, companies need to review their agreements in connection with force majeure provisions. In Mexican commercial transactions, unlike other jurisdictions, force majeure would apply by operation of law, if the contract is silent.
China will continue to require large amounts of LNG. In the short term, developers will have to team up with suppliers to create local markets.
A number of projects in the U.S. have been consolidating because they were more merchant-focused rather than having contracts with off-takers. LNG projects are complex and capital-intensive. Major oil companies need to be able to react quickly and be flexible in their approach in order to create new markets and efficiencies. Although prices of natural gas futures contracts for May delivery at Henry Hub were at $1.55 per million cubic feet at the time of this writing, the summer is expected to see increased prices — which will help with the U.S. economic recovery. In the long term, however, LNG has a very bright future.
Nicolas Borda is a partner and Ramy Morad is an associate at Reed Smith LLP.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
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