What is a Fuel Supply Agreement?
Fuel Supply Agreements are contracts between buyers and sellers that lay out the terms for the sale and delivery of fuel. Generally, fuel supply agreements include the origins (terminal or refineries) and destinations (terminals, refineries, to end users) of the product. In addition to price, fuel supply agreements also address the quantity and quality of the product to be bought and sold , pricing mechanism, taxes, fees, duties, transportation and delivery, variance allowances and claims, payment and payment security, volumes subject to the agreement, hedging, lead times, prorating, exclusives, specifications, performance standards and consequences, applicable law, assignment rights, dispute resolution, indemnification and representations/warranties/covenants.
Crucial Provisions in Fuel Supply Agreements
A fuel supply agreement is similar to a standard agreement in that there are key clauses and concepts, which are the building blocks of the contract which, if missing, could lead to a poor understanding of points of uncertainty and ambiguity. To the extent practicable, it is important to make sure that any agreement provides as much detailed information as possible about the relationship. Importantly, and as indicated below, fuel supply agreements contain generally accepted clauses commonly found where the buyer agrees to purchase certain types of fuel products from the supplier at a specified price.
A. Pricing Terms
The price terms will generally depend upon the nature of the subject transaction. For example, the price terms may be the following and will be artfully crafted so that the intent of the buyer and seller is clear:
B. Volume Commitments
A required volume commitment may be required because either the supplier wants a steady flow of business or the buyer promises to use a specific amount of a specific product in a given period. For example, fuels are often sold under "take or pay" contracts. In a take or pay contract, the buyer must take the fuels or pay for them even if those fuels are not required or there is no demand for the fuels.
C. Delivery Schedules
Similar to volume commitments, the delivery schedule is critical to performance of the contract. Common delivery schedules include, but are not limited to, the following:
D. Quality Standards
The fuel specification is very important to the transaction. The specification will often reference and incorporate applicable government entity standards.
E. Standard Clauses
Generally, the use of standard language is recommended. This allows the parties to enter into the contract knowing that the basic structure is already in place and would include items such as: Confidentiality; Term and Termination; Indemnification; and Arbitration/Mediation/Dispute Resolution.
Strategies for Fuel Supply Agreement Negotiation
The negotiation of a fuel supply agreement is a complex task that requires careful consideration of multiple factors by both parties. Each supply agreement should be considered independently of prior agreements with other suppliers as no two suppliers are the same and recent events in the market can substantially change the landscape for supplier negotiations. The demand for fuel and the capacity to supply it are driven in large part by the market conditions at any given time. If the economy is strong and demand is high, suppliers have greater flexibility to offer better terms to the sellers for their fuel. Conversely, if the economy is weak and fuel is plentiful, energy suppliers can be much more aggressive in their negotiations with sellers to obtain better terms. The bargaining power of both parties to an agreement can change from day to day and week to week depending upon the state of the market. Thus, it is imperative to focus on principal elements, or terms, on which to negotiate to ensure your organization has a complete understanding of what the agreement will require the supplier to provide and the seller to pay for the fuel. The following elements are intended to be only a guide and should not be considered "hard and fast" rules, but rather as a starting point, because appropriate terms will vary based on the unique situation of each negotiation:
- Duration — Fuel supply agreements, like many service agreements have a limited duration. For a fuel supply agreement, the duration is most often three years. That duration can be renewed, extended or shortened based on the negotiation between the parties. Typical renewals are one year with one renewal.
- Pricing Structure — Fuel suppliers generally offer two basic pricing structures: index pricing and fixed price. With index pricing, the price of the fuel fluctuates with the market index, often the NYMEX settled prices. Fixed price pricing does provide for price fluctuations based on the market and can eliminate out of pocket expense to the seller. For fixed price, the cost of fuel is a fixed price, usually on the first of the month, quarterly or annually with a penalty for early withdrawal or a credit if the supplier raises the cost of the fuel.
- Available Supply — The fuel supply agreement should clearly state the amount of fuel the supplier agrees to deliver and any other parameters regarding the use of that fuel.
- Termination — A fuel supply agreement should have a termination provision that clearly states when and how either party may terminate the agreement.
- Payment Agreements — Set forth payment terms that protect the interests of each party.
- Specific Requirements — Information should be included regarding specific requirements imposed by transportation services and/or terminals.
- Other Important Matters — Depending on the relationship with a supplier and the regulatory climate many other considerations may be necessary.
Legal Framework and Compliance Considerations
In addition to the commercial considerations, parties to fuel supply agreements must also be mindful of legal issues. For example, fuel supply agreements must operate within the framework of applicable laws that regulate the transportation, distribution, and storage of fuel oils. This is especially true of fuel oils which are not regulated as ordinary petroleum products. Compliance with federal, state, and local taxation laws applicable to fuel oils is also critical.
Dispute resolution is another important legal consideration. Often, fuel supply agreements contain provisions for mediation, commercial arbitration, or litigation in the event of a dispute arising from the agreement. Made generally unless the parties can point to some compelling reason for pursuing the dispute in court, arbitration is usually preferred because of its speedier resolution of disputes.
In addition to the foregoing , fuel supply agreements will contain legal terms and conditions to insure that each party is adequately protected from various types of risk. The most common types of risk allocation typically covered by a fuel supply agreement are freight costs; demurrage; quantity, quality, and inspection; payment provisions; fuel registration including proof of payment being made; other duties, taxes, levies, and charges; warranties; indemnification provisions; liability limitations; damages; confidentiality of information; contract assignment and delegation; and modifications to the fuel supply agreement. The language in these sections of an agreement will very often differ from supplier to supplier and from customer to customer. Each party must review these provisions, whether prepared by the supplier or customer, to ensure the best possible risk allocation. The purpose of reviewing and understanding these provisions is to avoid surprises when negotiating the next fuel supply agreement.
Common Issues and Pitfalls with Fuel Supply Agreements
While fuel supply agreements provide an outline of what a party can expect, they cannot account for every possible scenario. Parties must be ready to adapt and respond to changes within the industry, such as supply chain disruptions and price volatility. Fuel companies in particular have seen their margins squeezed by strained supplies and falling prices.
Supply Chain Disruptions: By their nature, fuel supply agreements are designed to take into account the risks associated with fuel price fluctuations. However, fuel supply agreements do not necessarily consider the sizable ramifications that accompany supply chain disruptions. A shipper may, for example, be required to pay the supplier twice its margin if its normal shipping route is blocked or disrupted. Incidents involving raw material affecting end-products may be held to be outside the scope of the supplier’s obligations, as will interstate and intrastate pipeline interruptions. On the other hand, breaches due to maintenance, low flow and equipment failure have been held to fall under the scope of the supplier’s obligations.
Price Volatility: Fluctuating prices and uncertain supply have long been familiar hurdles in the oil industry. The effects can be twofold: not only must the parties deal with a rising price point but a CPUC decision against a fuel distributor to require it to reduce its profit margin. In Bangladesh, balancing a growing population and energy consumption with a diminishing availability of resources has become a challenge for energy developers.
Solutions: Fuel supply agreements can address such disruptions by identifying material damages, setting minimum and maximum pricing, and designating a notice period. For example, in Chicago Steel Welding, Inc. v. Continental Can Co. of Illinois the defendant sought to introduce testimony concerning the adequacy of consideration, market price, bilateral trade arrangements and price competition. In its decision, the court found the trial court did not err in deciding that the plaintiff had met its burden of proof concerning lost profits, damages, plaintiff’s care in avoiding loss and the existence of contract damages.
Fuel Supply Agreement Case Studies
Case Study 1: A Regional Airline’s Agreement with an International Supplier
In 2017, a regional airline serving the Midwest entered a long-term fuel supply agreement for jet fuel with an international distributor. The regional airline receives all the fuel supplied pursuant to the agreement from a single terminal. Monthly volumes are supplied to the regional airline at a discount to the global market index price for such fuel, which varies depending on the quotation period. At the end of every month, the global market index market price is determined and deducted from a reference index price, and the resulting discount is the monthly contractual price per gallon. The size of the discount is inversely tied to the price of oil on the global market, meaning as the price of oil increases the discount decreases. In addition to the monthly price, the supplier receives an additional quarterly allowance that is calculated as a percentage of the monthly contractual price per gallon multiplied by the actual volume that the regional airline drew pursuant to the agreement during the quarter. The regional airline provides one month’s notice before any volume can be redetermined, upon which the new volume is effective for a rolling six month period. Once notified of a decrease in volume, the supplier is entitled to reallocate the allocated volume to its portfolio of customers and no longer has any obligations with respect to the volume allocated to the regional airline under the agreement to the extent the regional airline does not purchase the full volume during the rolling six month period.
Lessons:
Case Study 2: A Military Contractor’s Agreement with a Domestic Refiner
An aviation contractor leasing aircraft to the U . S. military, as well as providing maintenance, repair and overhaul (MRO) services to both the military and commercial customers, entered an agreement with a domestic refiner for the supply of jet fuel. In connection with the services it provides to the military, the aviation contractor supplies an estimated 1.5 million gallons of jet fuel per month to Hughes Air Fuel, Inc., an unbranded subsidiary of the aviation contractor. The aviation contractor pays the supplier in advance for the fuel, which is based on an estimated monthly demand of fuel consumption. Every month following the prepayment, the actual fuel drawdown is reconciled against the estimated amount and payments are adjusted with respect to any over or under payments. The estimated monthly demand is determined every month in advance of the subsequent month and agreed upon by both parties pursuant to the agreement. Both parties have the right to modify the estimated monthly demand at any time by sending a letter of intent to the other party. In addition to the regular base price, the aviation contractor receives certain monthly allowances, including a minimum monthly allowance, a reallocation allowance, a demand allowance, an early reallocation allowance, a true-up allowance and a redetermination allowance. Such monthly allowances are accrued to the aviation contractor against the monthly estimated fuel demand and subtracted from the monthly payments. The aviation contractor has the option to prepay the prepayment installation fee and additional allowances, which would give rise to lower costs in terms of present value in the form of reduced monthly payments.
