Take or Pay Contract Explained
A take or pay agreement is a contract used in business transactions to protect the seller against losses in the event that the buyer doesn’t meet the specified purchase levels agreed upon by the two parties. Alternately, if certain purchasing levels are met, the seller will provide goods to the buyer at a certain price. These agreements are frequently found in a variety of commercial contexts, including in the industry of oil and gas exploration and production.
In a standard take or pay deal, the seller sells and delivers a given amount of its product to the buyer, who pays for the product either at the time it is purchased or on terms established by the parties when the deal was made. If the buyer doesn’t keep up its end of the deal and the total amount of the product it takes from the seller in the long term is less than what was stipulated in the original agreement , the buyer must pay the seller for the shortfall.
If scaling back the bottom line is an organization’s goal, it can be hard to strike a balance between spending less money and adhering to the standards set forth in a contract signed with a supplier. This is where take or pay agreements offer an answer. Manufacturers across nearly every industry place orders with suppliers in accordance with these agreements, which cut down on unexpected costs and cash flow problems.
However, take or pay agreements are truly binding documents—the buyer has to follow through on its end or it will face legal repercussions. This means organizations need to exercise caution in how they use take or pay agreements, being sure to fully disclose their reason for use. For example, disregarding or neglecting the clauses of a take or pay agreement and renegotiating without cause can put an organization in serious financial jeopardy.
Industries Commonly Employing Take or Pay Contracts
There are several industries that most commonly use this type of agreement, which include the energy industry and the natural resources industry. The energy industry often uses these agreements for transportation to ensure that there are committed pipelines to deliver gas for certain periods, while the natural resources industry might utilize them for a consistent supply of minerals for mining operations.
Essential Elements Within a Take or Pay Contract
A take or pay agreement typically encompasses several key elements. Central to these contracts are minimum purchase obligations, pricing structures, and terms of delivery.
Minimum Purchase Obligations
A primary component of many take or pay agreements, these provisions require the buyer to purchase a pre-agreed upon amount of goods or services, regardless of actual usage. These mandatory quotas are critical to ensuring the continued viability of the producer-otherwise, the supplier would be left with an excess supply of products with no buyer.
Pricing Structures
The pricing mechanisms vary greatly from contract to contract and can be straightforward or complex. The price may be set as a fixed quantity at the outset of the contract or be tied to an index (for example, the New York Mercantile Exchange (NYMEX) for natural gas).
Terms of Delivery
The terms of delivery define the duration of the contract and the times and locations for the delivery of the service or commodities. In some cases, the terms of delivery also include penalties in the event of purchaser breach (for example, customary liquidated damages).
Advantages of Take or Pay Contracts
Take or pay agreements offer numerous benefits to both buyers and sellers. From the buyer’s perspective, the primary benefit is predictability of supply. For instance, an industrial consumer that is satisfying its own needs through a take or pay contract may be able to rely on the contract to raise financing for an expansion, or to establish itself within a vertical chain by having a reliable source of input. From the seller’s perspective, a take or pay contract offers risk mitigation. As stated by David Spaeth, owner of Alpha Gas & Oil Corporation, a Houston-based company that invests in oil and gas properties: "Take or pay contracts continue to be an important mechanism for reducing risk and providing cash flow certainty in a long-term contract." In addition, a take or pay contract’s guaranteed minimum payments can lessen the environmental risks of drilling for the producer. If the well is unsuccessful and fails to recover the take or pay obligation, the producer is only liable for the difference in the amount of the take or pay contract and the quantity the producer actually delivered. While it would be theoretically possible to construct an alternative contract that mimicked the price stability under a take or pay contract, these alternative contracts do not provide the same "right or duty" to take product. Moreover, the need for alternative contracts has not really arisen in the market place. On the one hand, if the prices of commodities are expected to rise significantly, the "buyer" will have an adverse incentive to purchase under the "take or pay" agreement in order to insure a fixed price of supply. Conversely, if the prices of commodities are expected to fall significantly, the "seller" would prefer to sell in the spot market to take advantage of the higher prices.
Disadvantages and Risks Involved
Challenges and Risks – Limitations and Disputes
Take or pay agreements are not without potential drawbacks, and it’s important to understand the potential risks for parties who cannot or do not meet contract or agreement terms. Almost invariably, these types of contracts become the focal point for subsequent legal disputes and litigation. While (as indicated in the section above) there is some provision for mitigating losses for the seller in the event of contract non-performance (in the form of buy-back agreements, for example), this additional development can also limit the potential profits of the seller and lead to a further loss of profit (because the buy-back price will almost always be less than the market price).
A scenario in which a buyer is having financial difficulties and is unable to meet take or pay agreement terms is not uncommon. In most of these cases, the seller can attempt to retain some profit through buy-back provisions that allow them to sell the excess gas , or they can sue for damages. However, if the buyer can prove that the seller knew the buyer was in financial trouble, the abatement of damages could be considerable under the legal doctrine of "election of remedies."
There are some other challenges involved with take or pay agreements. For example, the seller may not be in a position to deliver all of the products called for in the take or pay contract, yet they may not be able to recover damages or retain their profits if the buyer is in a position to sue the seller for breach of contract! State statutes and case law vary in terms of how damages and breach of contract are handled. In most jurisdictions, however, to recover under a breach of contract, the party seeking recovery must show that he has performed and that the other party has refused to perform their duties under the contract. As should be clear from what we have seen so far, take or pay agreements have the potential to cause considerable legal headaches.
Interpretation and Enforcement in Law
Take or pay agreements are legal contracts, and their enforcement falls under the body of contract law. Courts generally interpret these contracts according to their expressed terms. Thus, if the parties have included specific terms in the agreement, courts are likely to uphold those terms as long as they are consistent with the law. As such, the parties to a take or pay agreement should exercise care to ensure that the contract clearly states their rights and obligations to avoid future litigation.
Enforcement of a contract falls outside of the scope of the Natural Resources Code. The Natural Resources Code does not contain remedies for breach of contract. In the event of a breach, the party who is aggrieved will need to pursue a breach of contract claim to enforce the contract. The statute of limitations for breach of a written contract is four years. Tex. Civ. Prac. & Rem. Code § 16.004(a)(3).
The opinions of Texas courts suggest that arbitrating a take or pay dispute could be a feasible alternative to court litigation. See e.g., Oil & Gas Workers’ Union v. FERC, 192 F.3d 456, 484 (5th Cir. 1999); D&M Oil Co. v. Grayson, No. 2:12-CV-00109, 2013 WL 3305437, at *4 (S.D. Tex. June 29, 2013). The Texas Supreme Court has stated that it generally favors arbitration as a method of dispute resolution, Texaco, Inc. v. Pennzoil Co., 729 S.W.2d 768, 796 (Tex. App.—Texarkana 1987, writ granted), and has sanctioned the enforcement of arbitration clauses in agreements. See In re Rubiola, 334 S.W.3d 278, 285 (Tex. 2011). However, the Court has also held that "the judicial policy impelling arbitration is permissive, not mandatory, and is premised primarily on the desirability of limiting the courts to interpret and enforce contractual agreements to arbitrate and to relieve them of the burden of resolving private legal disputes." RSR Corp. v. Stone, 354 S.W.3d 859, 865 (Tex. 2011) (quotations omitted).
Take or pay agreements are often complex and may contain express or implied terms which may have several different meanings. Given this ambiguity, courts may not find a take or pay contract binding if the parties have not included certain key terms. Importantly, the parties must express a clear intent to create a contract; simple silence, such as failure to object, does not create an agreement. Windrum v. James Hardie Bldg. Prods., Inc., 565 S.W.3d 678, 683 (Tex. App.—Texarkana 2018, no pet.). Similarly, an agreement does not exist if the terms of the purported contract are uncertain, uncertain terms may be unenforceable if they do not give a court a basis on which to determine breach and relief. Vela, 40 F.3d at 841.
Take or pay agreements that cover extended periods of time may include a term stating the producer’s discretion regarding the amount of oil, gas, or water that the parties have agreed to collect. If the producer has discretion regarding when to take the commodities, and how much to take, then those will be material terms of the contract. Further, the agreement can state whether the producer must pay royalties on uncollected amounts and how the parties will address potential damages for breach. Each contract will have its own set of terms and conditions, so an agreement must include all material terms for the contract to be binding.
It is important to reiterate that contracts are legally binding as long as the parties have expressed their consent. A party who breaches a take or pay agreement could face legal recourse, which may result in significant penalties. An aggrieved party should consider their legal rights in the event of a breach by the other party.
Illustrative Examples and Industry Applications
Examples from the California Tug Boat Cases and International Cases
Several cases have found specific terms of a take or pay contract enforceable. In Tug McGraw Tugboat Corp. v. American Commercial Barge Line, 50 F.3d 509 (1995), the Court of Appeals for the Second Circuit enforced as valid a definitive take or pay exclusion clause that precluded the shipowner from synchronizing vessels from its own fleet with the tugs that the customer got from the provider. The court noted that the contract was signed by the parties after they had each been represented by counsel who was admittedly very sophisticated, and thus the intent of the parties must have been to exclude the customer from any synchronization with the tugs. As such, the court concluded that the clause signified a definite obligation to pay for certain services whether or not the services were used.
There was no reciprocity within the Texas courts. In favor of the defendant in a take or pay for minimum throughput or take or pay for a minimum quantity of waste transaction, the trial court in Jones and Laughlin Steel Corp. v. United States Steel Corp., 757 S.W.2d 799 (Tex. App. – Ft. Worth 1988, writ denied), relied upon the American Society for Testing and Materials (ASTM) definition of take or pay as "a bill and pay provision which guarantees the seller will be paid for certain minimum quantities of service, whether used by the buyer or not." Because the take or pay provision had been breached by the defendant for not paying for the service that it had not used, the Court of Appeals of Texas wrote, "[b]ut take-or-pay provisions do not cover situations where the customer does not actually receive the service. A license to mislead others with one’s conduct is not a proper subject of law."
Future Prospects of Take or Pay Agreements
As the global economy evolves and demand for energy and raw materials continues to grow, it is likely that take or pay agreements will remain an important component of transactions in economic sectors characterized by high capital expenditures and long payback periods. We also expect to see more sophisticated and complex contractual frameworks being developed to finance and provide security for the investments in assets and infrastructure needed to meet growing global demand.
It is worth noting that certain developments in market dynamics may affect how take or pay arrangements are structured in the future . For example, the drive to decarbonize the global economy is expected to result in an increase in take or pay contracts in the energy sector, especially for renewable energy projects, including solar, wind and battery storage projects, which typically benefit from reliable sources of revenue and the ability to enter into long-term supply arrangements. Further, electronic trading platforms have emerged that facilitate the trading of commodities over the internet. Some commodity trading platforms have even started settling contracts and collecting payments, thereby becoming central clearing houses, which reduces the counter-party risk of both buyers and sellers. While these trends are generally promising, buyers and sellers of commodities will need to be vigilant and proactive to ensure that their interests are adequately protected and that their ability to close transactions is not compromised.
