The Maui Gas Contract - A Brief History

March 1998

Part B

Introduction

The aim of this presentation is to provide an overview of the various provisions of the Maui Gas Contract. As some of you may be aware, I have acted for the Maui participants either individually or collectively with respect to a number of different issues arising under the Maui Contract. As a result of this participation I have on occasion provided advice on the meaning of various provisions of the contract. Accordingly I hope you will appreciate that while I am happy to refer to some issues that arise out of the contract in many cases it will not be appropriate for me to express any views.

I do not think that any of you should see this as any particular disadvantage. There is no shortage of people prepared to express their opinions about the Maui Contact, there being a minor industry associated with giving different opinions or expressing different views on its provisions.

In short, by all means raise questions but I will not necessarily be in a position to answer them today.

Contract Overview

The Maui Contract was signed in October 1973. The original Sellers were Shell, BP, Todd and Offshore Mining, a Crown owned company, with the Crown as Buyer. I have prepared a short paper that summarises the history of the contract and the 1990 contracts which you can read at your leisure by way of further background.

The Maui Contract is a supply contract. Unlike the Kapuni Contract, there is no dedication provision. In other words the Maui Mining Companies (MMCs) are obliged to meet their supply and delivery obligations as set out in the contract but the Maui field is not dedicated to the Buyer. Thus the contract has a finite life that may not coincide with the life of the field.

While the contract is a supply contract it is also has take or pay provisions meaning that the Buyer is committed to either taking a specific quantity of gas in any given year or, if insufficient gas has been taken, to pay for that quantity and accumulate a prepaid gas balance. There are therefore significant commercial incentives for the Buyer to consume up to the take or pay quantity in any given year.

The Maui Contract is also a bundled contract - that is the Crown receives gas under the contract on a fully delivered basis at any one of a number of delivery points off the Maui line. There is no provision in the contract separating out the costs for transmission and energy.

However the most important thing about the Maui Contract is its size and scope. The quantities of gas involved are large - the current production rate is approximately 165 PJ per annum with initial reserves of over 5000 PJ. The term of the contract is for 30 years. While the MMCs do not themselves publish sales figures for Maui production some insight into the numbers involved can be obtained from the 1997 Annual Report of Fletcher Challenge Energy. That report noted that the Maui field generated revenues for Fletcher Challenge Energy of $530 million. These figures included revenue from condensate and oil production. Given that Fletcher Challenge Energy has 68.75% of Maui, the total revenues from the field extrapolate to approximately $800 million. Obviously this figure can fluctuate considerably depending on the current oil price. Without doubt the gas contract itself is a key driver in relation to these revenues. Applying a current Maui gas price (exclusive of the Energy Resources Levy) of $1.51 per GJ the current annual revenues from Maui gas alone are approximately $250 million.

A further remarkable feature of this contract is that it is an entirely public document. A copy is publicly available in the form of the "White Paper on the Development of the Maui Gas Field". There have been a number of amendments to the contract but, for the most part, these are not material to an analysis of the contract. Anyone can go and read the contract if they wish.

The contract comprises 21 Articles and 13 Annexes. It was the result of literally years of negotiation between the MMCs and the Crown as Buyer. The history of the negotiations is summarised in the White Paper.

The final point to note is that in 1990 the Crown entered into a series of agreements whereby the Crown has entered into agreements to onsell all gas acquired under the Maui contract to each of NGC, ECNZ (now Contact) and NZLFI, now Methanex. These contracts are often described as "back to back" agreements. I have never been sure precisely what a "back to back" agreement is. What is clear is that the Crown remains the principal obligor. The MMCs still enjoy sovereign risk in terms of the Crown's obligations as Buyer. There is no direct contractual relationship between the MMCs and any of NGC, Contact or Methanex in respect of Maui gas.

An Article by Article Analysis

I shall now provide a brief commentary on each Article of the agreement. Before doing so it is worth mentioning that the Maui Contract is unusual in that there are no recitals. Many of the other agreements included in the Maui White Paper have recitals but they are no where to be seen in the Maui Gas Contract. It simply means that there is no general statement of intent as to what the contract is aiming to do. We therefore have to rely on the specific words of the contract in each case.

Article 1

This is the interpretation provision. Rather than comment on any specific definitions at this juncture, it would be preferable to refer to various defined terms as necessary in the context of their use in particular Articles.

Two exceptions are the definitions of the "Maui field" and "Gas".

The Maui field is described in Annex A and said to "comprise all petroleum producing formations down to a depth of 12,000 feet sub sea" and located within the area of the relevant licence. Thus, if there is any petroleum producing formation below 12,000 feet, it is not part of the Maui field for the purposes of the Maui contract.

"Gas" is defined as all wellstream effluent from wells into the Maui Field. Thus, all gas produced from any wells, irrespective of whether that gas is produced in association with oil or condensate production, is "Gas" for the purposes of the contract.

Article 2

This is arguably the main operative Article of the contract. The Seller agrees to sell and deliver gas and the Buyer agrees to purchase. If only things could stay this simple!

Article 3

This Article sets out the term of the contract and the terms pursuant to which gas is required to be delivered under the contract. Articles 3.2 and 3.4 are now redundant for ongoing operational purposes as they deal with initial deliveries of gas only.

Article 3.1 provides that the term of the contract is 30 years from the date of first delivery. Deliveries first commenced in June 1979. Thus the contract can be terminated on 27 June 2009. Pursuant to the provisions of Article 3.1.1 it should be noted that the contract continues in force "until terminated on the expiration of twelve months notice in writing given by one party to the other". In other words, the contract will continue in effect unless one of the parties takes the step of giving a termination notice.

There are various other provisions to deal with the circumstance where the contract continues.

Article 4

This provision sets out the warranties given by both Buyer and Seller.

Each of Buyer and Seller warrant that they will act as Reasonable and Prudent Operators - an expression that is defined in Article 1. A key provision is the obligation in Article 4.1.1 that Seller "... drill all necessary wells and ... install all necessary production and related facilities including processing plant and pipelines to enable it to fulfil its obligations under this contract".

The exact nature and extent of Seller's obligations in this regard has been the subject of a great deal of discussion and debate. Obviously a key variable is defining exactly what is meant by Seller's obligations. This subject comes up later in a different context.

The Seller warrants that it will give good title to gas in Article 4.1.2.

Article 4.3 is an important provision. In this provision, the Seller undertakes that it will not sell any production for the Maui field if that sale "would, having regard to the then current assessment of Economic Recoverable Reserves, impair Seller's ability to meet any of its obligations under this Contract".

This is a promise by Seller that it won't sell any gas if by doing so Seller will not be able to meet its future obligations. It again begs the questions as to the exact nature of Seller's obligations.

However, what you should all note is that if the Economic Recoverable Reserves are sufficient, the clear implication of Article 4.3 is that the MMCs are free to sell Maui gas to any third party. This is confirmed by Article 5.4, referred to below, which specifically entitles Seller to sell Maui gas to third parties.

Article 5

This sets out a series of Seller's reservations or statements about what the Seller can do. Thus the Seller is given the right to:

• decide the manner in which all Maui operations are to be conducted (Article 5.1);
• use gas in the course of the conduct of its operations (Article 5.2);
• process gas to extract LPG etc (Article 5.3); and
• sell gas to third parties - subject of course to Article 4.3.

Article 6

This is an Article that has been the subject of much intense scrutiny. In broad terms, the clause sets up a regime for:-

• settling the initial quantity of Economic Recoverable Reserves or ERR;
• ensuring that information about the estimated quantity of ERR is made available to the Buyer; and
• establishing the mechanism to review from time to time the quantity of ERR.

The importance of this Article is that the ERR figure, once determined, establishes the extent to which Seller will have sufficient gas to be able to sell to third parties or whether there needs to be an adjustment to annual quantities and daily quantities if reserves are insufficient to meet future delivery obligations. It is scarcely any wonder therefore that the purchasers under the 1990 contracts have every reason to exhaustively scrutinise every nuance of Article 6.1.1 in order to establish the exact nature and extent of their rights.

The contract itself does not provide very much guidance as to what is meant by ERR. Article 1 somewhat laconically defines this expression as "the quantities of Gas that are estimated to be economically recoverable from the Maui field".

In this context it should be noted that "Gas" is also defined in Article 1. "Gas" means produce from wells in the Maui Field after treatment to conform with the gas specification. Thus any LPG that Seller is permitted to extract (Article 5.3) and own use gas (Article 5.2) can be included in the ERR figure.

Ultimately, ERR is simply a number that is either agreed between the parties on such basis as they may themselves determine or as is determined by an independent expert pursuant to Article 6.2.

What may be of some interest to you is that over the course of the life of the Maui Contract there has never been a recognised or formal determination of ERR. For the sake of completeness it should be noted that in 1981, a reserve level was apparently agreed at about
149,000 million³.

Article 7

This provision requires all gas delivered to Buyer to meet the gas specification. There are quite lengthy provisions that deal with the consequences of Seller delivering non-specification gas but, so far as I am aware, Seller has at all times delivered only specification gas.

The Gas Specification was last modified as recently as 1997 with the current specification being in the same range but tighter than the overall standard specification for all reticulated natural gas.

Article 8

This is a critical provision. It sets out the quantities which Buyer has a right to purchase under the contract. The quantities entitlements are set out in a sequence consisting of:

• annual quantity or AQ;
• daily quantity (or DQ) - being 1/365 of the AQ;
• maximum daily quantity (MDQ) which is approximately 150% of the DQ;
• the maximum hourly quantity (MHQ) which other than between the hours of midnight and 8.00 am is approximately 160% of 1/24th of the DQ.

All of the quantities are set out in a table which forms part of Article 8.1.7.

As noted earlier, it is not entirely clear what is the exact amount of the quantities of gas that Seller is obliged to deliver. Buyer has a clearly stated right to purchase gas on each day equal to the MDQ for that day. The Seller must maintain a capacity to deliver that quantity. However, it is equally clear that if the Buyer had called for delivery of gas at this rate from the outset of the contract then there is no way the contract could possibly have had a 30 year term - the field would have been depleted some time ago. Furthermore, it is clear that the original reserves estimate, as published in the White Paper, was not sufficient to permit constant deliveries at MDQ. Accordingly the exact quantum of Buyers forward purchase rights remains an uncertain issue.

The balance of Article 8 contains a number of provisions allowing for adjustments in the quantities. Article 8.2 is largely now history as are Articles 8.3 and 8.4.

Article 8.5 continues to have importance.

Article 8.5.1 provides that during the so called summer months (November, December and January) the MDQ is reduced by 20%.

Article 8.5.3 is perhaps more interesting. Under this provision if Seller needs to carry out scheduled repairs and maintenance then Seller is entitled to cease deliveries while the work is carried out.

The operator of the Maui field has had a remarkable record in that it has only rarely found it necessary to carry out scheduled repairs and maintenance in a way that has disrupted gas deliveries. However, the effect of Article 8.5.3 is that if Seller is required to effect repairs then its delivery obligations are suspended and, irrespective of any take or pay consequences for Buyer, there is no adjustment to the take or pay quantity in that year.

Article 8.6 sets out the notification requirements and allows for variations to the notifications in certain specified ways. I am given to understand that it is only in more recent years that there has been much tighter adherence to the particular notification regime as set out in the Maui Contact.

However, it is Article 8.8 that is probably one of the more interesting provisions in the contract. This provision deals with the quantities adjustment mechanism in the event that ERR are determined to be insufficient to enable Seller to meet its obligations through to the end of the term of the contract. Precisely how this provision works has been the subject of much analysis and debate and it is of obvious importance to purchasers of Maui gas, especially those who have substantial prepaid gas balances. In order to gain some understanding of the nature of the problem it may suffice to quote part of Article 8.8.3 which sets out what any downward adjustment is required to do if Seller can't meet its DQ obligations and after having made the more precise downward adjustments provided for in Article 8.8.2. Article 8.8.3 provides:

"... the Daily Quantities for each remaining Year of this Contract shall be reduced to such a level as will deplete below the level of economic recovery the Gas available from the Maui Field over the remaining term of this Contract, or to such higher level as may be mutually agreed for a correspondingly shorter period."

It would be fair to state that this does not exactly constitute comprehensive guidance. There is little relationship between the depletion curve that will yield maximum production for Buyers or maximum revenues to the MMCs and no guidance as to what is meant by "the level of economic recovery".

In short, some members of the legal profession can be forgiven for ardently hoping that ERR will be less than Sellers forward obligations. Similarly, all those who purchase Maui gas should be anxious to avoid the perils and inherent uncertainties of an in depth investigation and dispute as to the exact meaning and application of Article 8.8.3.

Article 9

This is the take or pay provision which is at the financial heart of the Maui Gas Contract and which provided the financial underpinning for the whole of the Maui development.

Article 9.1 sets out the price of Maui gas. The original price was approximately 35 cents per GJ but the contract establishes an elaborate mechanism for escalating the Maui price. Essentially the price escalates at the greater of half the inflation rate or the full rate of inflation less 3%. The inflation rate is determined by reference to the Producers Price Index.

Thus if there is an inflation rate of 3% the price increase will be up by 1.5% on the preceding year. A 10% inflation rate would result in a 7% price increase. It is a complicated price adjustment formula - see Article 18.2, but it appears not to have caused any substantial problems during the course of the life of the Maui contract. The current price is $1.51 per GJ.

Article 9.2 is the take or pay clause. It is in fact a very simple provision and reads as follows:

"Buyer shall, in each Year, whether or not it has taken delivery of the same, pay for a quantity of Gas not less than the Revised Annual Quantity."

The Revised Annual Quantity is in turn defined as being the Annual Quantity for that year less a series of reductions which in practice have only limited application. For most practical purposes the AQ is the take or pay quantity.

The importance of Article 9.2 can hardly be overstated. In every year but two, Buyer has failed to take gas up to the Revised Annual Quantity. In other words, in almost every year of the contract Buyer has been required to pay for and has not taken a certain quantity of gas. As a result the Buyer has now accumulated a very substantial prepaid gas balance.

Article 9.3 sets out the mechanism by which gas paid for but not taken can be accessed by Buyer. In essence Buyer can only call for deliveries of prepaid gas if they have already taken the take or pay quantity in any year. In other words, only when Buyer takes in any year the take or pay quantity can gas taken thereafter be treated as a delivery of prepaid gas and need not be paid for.

If there is still prepaid gas left in the last three years of the contract then prepaid gas can be taken in preference to gas that must be paid for.

Article 9 has not finished with its controversy. Another provision that has been exhaustively analysed over the years is Article 9.4. This provision specifically entitles Buyer to onsell Maui gas. But:

• Buyer must tell Seller the terms on which the gas is sold;
• the Buyer retains the whole of the take or pay liability;

In certain circumstances Buyer is required to make payments to Seller for gas onsold above a specified quantity - the payment effectively being the whole of the gross margin that Buyer may make on the onsale - see Article 9.4.1(d).

The way this provision now operates has been considerably complicated by the provisions of the State-Owned Enterprises Act 1986 (and various amendments to that Act) which has meant that certain state enterprises, in particular, Contact and ECNZ are, it is said, no longer bound by Article 9.4.1 and need not account to Seller for any part of the proceeds of gas on sold by them. Whether that is or isn't true is not a proper subject of this paper. However, what can be said is that no payments have ever been made by the Buyer to Seller pursuant to the provisions of Article 9.4.1.

Article 9.5 and 9.6 concern themselves with various taxation issues. They occupy no less than 14 pages of the contract. I confess that I have never understood these provisions, never studied them and I intend to keep it that way. They are provisions that are as dense as they are arcane.

Article 10

This provision sets out the points of delivery of the Maui Contract. What is interesting is the numerous mentions of the Auckland power stations - intended to be a principal consumer of Maui gas at the time the contract was entered into.

In broad terms a more important part of Article 10 is that it articulates the bundled nature of the contract. Seller is obliged to deliver gas all the way from the Maui field through the Maui line to various points near Huntly and New Plymouth.

Article 11

This clause is relatively simple and says that title to any gas transfers to Buyer at the time of delivery. Seller is responsible for the gas until so delivered.

Article 12

This provision sets out the invoicing arrangements and no great controversy arises in these provisions. The only point of interest is the reference in Article 12.4.2 that any dispute about "the accuracy of any invoice" can be referred to an Independent Expert. What is not so clear is the extent to which the basis upon which an invoice has been determined - which may involve a large number of highly complex contractual interpretations, can be the subject of an independent expert determination or simply the accuracy of a calculation that makes up the invoice.

Article 13

This could be described as a classic old fashioned force majeure cause. Those of you in the legal profession may be interested to know that Article 13 has been the subject of some litigation which was settled before going to trial. It has therefore been the subject of reasonably intense scrutiny. What is tolerably clear is that it is a clause that is solely between Buyer and Seller and any purchaser of gas from the Crown should not automatically assume that that purchaser is entitled to the benefits or protection of this clause. Similarly, force majeure suffered by a purchaser from the Crown will not necessarily constitute a force mejeure event suffered by the Crown and entitle the Crown to the relief provided for in Article 13.

Article 14

This a most interesting provision. It states that the maximum liability of the Buyer is simply a liability to pay for gas not taken in accordance with Article 9.2. In other words, if for any reason Buyer cannot or does not buy any gas then its maximum liability is its take or pay obligation. Any of Sellers consequential losses such as loss of condensate revenues, are, on this analysis, not recoverable by Seller from Buyer.

Article 14.2 similarly limits the Sellers liability. Seller is required to compensate the Buyer for all costs, expenses and damages that are incurred by the Buyer as a result of Sellers failure to deliver. The originally stated maximum liability for any single failure was $10 million but this figure is escalated annually at the same rate as the gas price increases. The current maximum liability figure is $43 million. In other words, using today's Maui gas price, the maximum liability of Seller is equivalent to approximately 29 PJ of undelivered gas.

The other point to note about the lability provision is that there are specifically excluded from Seller's compensation obligations "any damages awarded against Buyer in favour of, or sums paid by Buyer by way of settlement to, any third parties..."

Given that the Crown onsells all Maui gas it buys this is a substantial exclusion.

Article 15

This sets out a series of miscellaneous provisions (notices, no waiver, governing law etc) and contains nothing unusual.

Article 16

This sets out the provisions for reference to an independent expert determination. What should be noted is that there is no general arbitration clause in the Maui Gas Contract and there are only a limited range of matters that can be referred to an independent expert under the contract. These matters include:

• settling quantities entitlements if the contract is extended (Article 3.1.3);
• determining ERR (Article 6);
• determination of disputes about non-specification gas (Article 7);
• resolution of disputes about tax adjustments (Article 9.6.8(b));
• resolution of invoicing disputes (Article 12.4);
• resolution of disputes about liabilities (Article 16).

Disputes about appropriate quantities adjustments in the event of a shortfall in ERR (as required under Article 8.8.2 and 8.8.3) cannot be referred to Independent Expert determination.

Article 18

There are two aspects to Article 18. The first part of Article 18 - Articles 18.1 and 18.2, sets out the detailed gas price reassessment procedures. An examination of Article 18.2 indicates that the formula for calculating the revised prices is, on initial appearances at least, reasonably complicated. I am given to understand that calculations of the reassessed price now present no substantial difficulty.

Article 18.3 is however a much more interesting provision. This sets out the post facto review procedures.

Post facto review is a concept which is unique to the Maui Contract. It arose as a result of considerable uncertainty in 1973 as to the cost of developing the Maui field. The Maui joint venturers were concerned that they could be exposed to substantial cost blow-out and wished to establish a mechanism by which they could recover some of that cost from the Crown following a post facto review. For its part, the Crown wanted to ensure that if the cost of development was less than expected it would receive some form of financial compensation.

As many of you will be aware, the cost of developing Maui was vastly more than was originally anticipated. The MMCs therefore now have a real interest in pursuing their entitlement to a post facto review. As you might expect the Crown has a somewhat different view of its obligations and has been resisting the notion that it may be under any liability to make a post facto review payment.

What can be said is that the stakes in this dispute are large. Hundreds of millions of dollars are being contested for with the risk of payment being on the Crown. There appears to be no reasonable prospect of the MMCs having to make any payment. The exact way in which the clause operates is far from crystal clear and it is the subject of litigation which is now at a relatively advanced stage. The risks for the Crown are considerable while the potential benefits to the MMCs are significant. Some of us will be very interested to see exactly what a trial judge will make of the various contractual provisions.

Article 19

This simply sets out the measurement mechanisms.

Article 20

This makes it clear that MMCs are jointly and severably liable for the obligations contained in the contract but are deemed to sell Maui gas severably and not jointly.

Conclusion

That then is the Maui Gas Contract.

As noted at the beginning of this paper this contract provides the financial and legal underpinning for the whole of the Maui development. Without this contract there would have been no Maui development.

It is a contract that contains more than one or two curiosities and anomalies and has often been the subject of criticism. However for my own part, I continue to look at this agreement with genuine admiration for its authors and draftsmen. When one considers the time and context when the contract was prepared it is a remarkable piece of work. In 1973 there had been only a few large scale take or pay gas contracts in the world. Moreover, Maui involved gas which was to be sold into a country without any large scale gas reticulation network and no large consumers of natural gas. The contract was prepared without the benefit of word processors and without the benefit of any extensive array of precedents. No doubt there were numerous economic calculations about what the parties could expect to receive over the life of the contract. But, Excel spreadsheets were of course unheard of and inevitably there could not possibly have been the same level of sophistication and economic analysis that one would now routinely expect in any modern gas contract. But this is a contract that still speaks with considerable eloquence even today. It has demonstrated its durability and continues to be, by far, the most important petroleum contract in New Zealand.

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