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Physical Oil Trading and Formation of Sales Contracts

Fiziksel Ham Petrol Ticareti ve Petrol Satış Kontratlarının Oluşumu

Yamaç GÜNEYLİ

Today international oil trading industry has been characterized by the dominant position of Multinationals, major traders and NOCs. In return, they all received a stream of income through oil trading under enforceable contracts. Our focus is not only on the mechanism of oil trading market but has to be the words and the parties’ conception of the sales contract to be signed.We ask what the parties’ intention at the negotiation process and what the words in a preliminary written agreement would mean for Judges. The answers necessitate that promises in negotiation should manifest an intent to be bound and meeting of minds for a potential transaction should be clearly understood through the view of the 3rd party.Although this article is intended as a beginner guide, I hope it will also find favor with the more experienced energy counselors.

Physical oil Trading, Oil Sales Contract, Contract Formation, Objective Assent, Meeting of Minds.

Bugün uluslararası ham petrol ticareti, baskın pozisyondaki Çokuluslu petrol şirketleri, başlıca büyük simsarlar ve milli petrol şirketleri tarafından şekillendirilmektedir. Buna mukabil, bu şirketler icra kabiliyeti yüksek kontratlar çerçevesinde ham petrol ticareti yoluyla büyük bir gelir akışından pay sahibi olmaktadırlar. Bu yüzden çalışmamızda, öncelikle petrol ticaretine ilişkin piyasanın işleyişi kısaca anlatılmış, sonrasında piyasa oyuncularının imzaladıkları kontratlardaki sözleri ve kavrayışlarıyla ilgilenilmiştir.Sorulan sorular, tarafların müzakere sürecindeki niyetlerinin ne olduğu ve tarafların üzerinde anlaştığı ön metindeki sözlerin hakim için ne anlama geldiğidir. Verilmesi gereken cevaplar ise, müzakere sırasında verilen vaatlerin, sözleşme ile bağlı olma niyetinin bir tezahürü olmasını ve potansiyel bir alışveriş için iradelerin ortak bir noktada buluşmasının 3. Kişiler tarafından bile açıkça idrak edilmesini gerektirmektedir.Bu makaleyi yazmaktaki amacımız konuya ilk kez hasıl olanlar için bir rehber niteliği taşısa da, makalemin enerji konusunda daha deneyimli hukukçu ve danışmanların da dikkatini çekeceğini umut ediyorum.

Fiziksel Ham Pterol Ticareti, Ham Petrol Satış Kontratı, Kontrat Oluşumu, Objektif Rıza, İradelerin Buluşması.

SECTION I - OIL TRADING & TURKEY

Oil trading is mostly categorized into two groups: Physical oil trading and Paper trading. Considering the aim of this article, physical oil trading is purely transferring the title and risk of crude oil from one party to the other at a specified time and location under a variety of contract type including ‘spot’ transactions or ‘term’ contracts1 .

Physical oil trading is the lifeblood of world economy and equally important, of political strategy. That’s the reason why oil trading includes globally competitive and highly liquid deals. Before entering a deal, making a good decision in crude market, depending on some key factors, i.e. security of supply, price speculations, price volatility, transportation of oil, etc., is based on knowledge, experience and insight. When looking at the big picture, the vital issue, however, is not to make a decision but to make a solid and binding contract.

Let’s closely look into the trading business. In trading business, energy commodities are comprised of crude oil and oil products, natural gas and coal. Physical oil trading, however is relatively a difficult part of that business. Daniel Jaeggi, Vice President of Geneva-based oil trader Mercuria, simply replied what the trading is question that the physical oil trading is bringing the oil from a place where the people do not need them to a place where they are needed2 .

What concern us here is that we have to visualize the physical oil trading cycle in spot sales before getting deeper understanding of crude oil sales contract. Typically there are three major players, participated in crude deals. Producers such as International and National Oil Companies (IOCs & NOCs) are on the seller side of deals. Conversely, refiners are on the buyer side. Lastly, oil trading houses together with IOCs and NOCs are in a position to be both seller and buyer. How to be on both sides in general? Under a fluctuated change in fundamentals in oil markets, these players adopted their structures by vertical integration. The words of other, they have owned not only production fields but also refineries and other related facilities between them. Unlike the integrated companies, trading houses offtake oil from producers of all sizes and manage its trading, storing, financing and supply to refineries. In short, they have started to buy and sell crude oil in physical and derivative market in order to maximize their profits and live longer.

Another important point is that up to 90% of world oil trade is seaborne and about 70% of the vessels carry commodities that includes oil tankers and bulk carriers. Important oil trading hubs are located in Asia, Europe and North America. For example, Rotterdam is the Europe’s largest trading port. In this respect, if you are a producer and do not have a logistic, then you should sell your crude cargo on a FOB basis that means title and risk of oil pass to the buyer or trader once delivered on board to ship by seller because physical oil trading involves freight transport mostly by ship. That clearly shows us the major activities of trading houses involves buying crude oil, shipping it from loading terminal to discharging terminal at higher price in order to cover their costs and make a profit3 .

Ultimately, transactions between traders and buyers end up either long term crude supply contracts, generating the majority of refinery contracts or one-off deals on the spot market4 . Extensively, one-off deals for immediate delivery are rare. Instead, the parties choose to agree on the price at the time of contract, in which case the one-off deals becomes closer to a “forward contract”. More specifically, the pricing of a cargo is mutually linked to the time of loading5 and then, sale contract has transformed to an intertemporal attitude that parties agree today to exchange trade promises later6 .

SECTION II - OIL SALES CONTRACT & RELATED DISPUTES

The law of contract is about the enforcement of set of promises7 , the breach of which the law gives a remedy. To make the promises enforceable, judges consider the contract as a whole with all surrounding facts of the particular deal and seek the presence of certain elements. These elements essential to form a contract are to be found both the negotiation correspondences and in the contract itself8 .

At any transaction, the “What evidence of objective intention does the law require?” question has an intense dimension in commercial deals as contracts are based on substantial negotiation related to exchange of cash for goods and spells out the duties and responsibilities of each contractual party. So, the process begins with an offer. An offer is a proposal by the “Offeror” to enter into a contract. That is to say, it must be made with the intention to become binding upon acceptance. When considering the status of commodity supply tenders, company selling the goods sends an Invitation to Tender (ITT), the people willing to buy them makes the offer. Still controversial, an ITT for a definite quantity of goods to be sold or delivered at a specified time is either held to be an offer or an invitation for offers to be submitted. Clearly the latter’s acceptance does not create a binding contract. Then, acceptance occurs when the “Offeree” accepted the offer by conduct or by words. Objective intention can clearly be seen in the response giving an assent to offer in terms of offer precisely. Note that, a contract is formed by unconditional acceptance to the precise terms of offer. This is called ‘Mirror Image Rule’. Where the offeree accepts something more than promised in the offer, a counter-offer, qualified expression of assent, does not constitute a binding acceptance9 but causes a position reversal. The original offer is effectively terminated and the counter-offer itself become an offer. If it is not rejecting the original offer, then the offeree can bargain for different terms.

An offer continues to exist until it expires. Therefore, the offeree must accept it within the specific time. If no such time is mentioned, duration of offer will expire within a reasonable time10 objectively understood by a reasonable person. Equally important, consideration11 , which turns a gratuitous promise to a prompt commitment, is essential to restrict the offeror from revoking the offer. However, as an exception “firm offer” as defined at UCC §2-205 is an offer that cannot be revoked for a certain period of time stated in the written offer12 .

It is also particularly important to determine when the contract is formed if the parties interact for negotiation via e-mail. It is a general rule that an acceptance is effective as soon as the offeree dispatches it for communicating to the offeror. In contract law for determining the time at which an offer is accepted, the ‘Mailbox rule’ states that an offer is considered accepted at the time when it is placed in the mailbox13 .

Ultimately, for an agreement to be a contract, it must be required to settle on the terms of the contract. Contract terms can be categorized into express terms and implied terms. Express terms are those agreed between the parties themselves in the contract. So, the court easily finds out the parties’ intensions in the document itself. Indeed, “ordinary and natural meaning” of the words, as a solid rule, will be found as they are written down14 . If an express term is not fulfilled, the innocent party may bring an action for breach of contract. However, things are not that simple in practice as can be seen later sections since defining a contract to be formed even if all express terms were agreed before can be controversial issue for contractual parties. Conversely, implied terms are secondary terms which are not expressly stated but which are implied. The parties show their assent by conduct rather than by clear words. In particular trades or industry, court will apparently recognize the implied terms into the contract as of its reflection of the particular industry’s standard practice15 .

In contract law, some concepts such as offer, acceptance, mutual assent and intent should be considered within contract’s entirety under the doctrine of consent. In other words, mutual assent to a contract is maintained when a party makes an offer and the other is accepted under an intention to be bound by contract terms. Courts have to rely on observable evidence to ascertain whether parties consented. But in reality, parties either could have intended to enter into contract and signed the contract and yet there might not be actual “consent” or could not have kept their intention despite giving consent to transaction. In event of any dispute arising out of the contract, courts should find out the elements of mutual assent forming the contract. In the absence of contract, neither party will be bound to the conditional promises they have made.

Necessarily, the doctrine of consent has been developed by courts to assist contractual parties in a dispute. Objective approach has been adopted to make sure the certainty of contracts and other party’s reliance on the promisor’s manifestation. This approach provides the court to assess the expression of Parties’ intent. For assessing whether a party has consented, courts focus on evidence such as contract signature, spoken words or written correspondences, or other actions related to transactions. However, it is important to bear in mind that continued reliance on “Consent” will create a deeper disconnect between contract law and market realities16 . Therefore, it is perhaps understandable to consider the special features of market of the time of contracting when trying to resolve particular uncertainties arising out of the contract.

Contract law also contains a number of doctrines tend to support the written contract considered to be the best evidence of parties’ consent. For example, “Four Corners Doctrine” advocate that the judges must stay within the four corner of the contract when interpreting a written contract to be sure the parties’ intention17 . Likewise, “Plain-Meaning Rule” focuses on contract’s plain meaning if the terms of the contract are obvious and enough clarity18 . The classic doctrines ignore the subjective intent of the contracting parties and advocate textualist approach to determine what was agreed upon. But whatever one’s opinion on the subject matter, the focus is not on the language-based approach but rather contractual parties’ intentions under meeting of minds as a final expression.

Oil sales contracts are sui generis contracts including the details of special operations and technical terminology that requires a unique interpretation. Because of the very nature of what is being supplied, contractual parties are aware that the subject matter of the contract (i.e. crude oil) may well be discharged and processed in refinery in whole or in part before payment is due. This is important because the contract enforces certain obligations that must be satisfied before the seller demand the payment.

In volatile oil markets, buyer have a chance to make a spot purchase (a simultaneous exchange of cash for oil cargo) or an enforceable contract for future delivery. In order to make a contract first thing has to make a tender. A to-do list for oil sales starting with invitation to tender (ITT), seller is sending an offer of a specific spot cargo with the intention of becoming binding upon acceptance and asking a price differential as a premium or a discount. To form a contract, there must be an acceptance of the offer by words or conduct. By the very nature of the oil market that have frequently fluctuating prices, the offer is to expire within a relatively short time period such as hours or a day. If buyer, in theory, send an acceptance, it can be an amicable consensus on needed terms that would form the contract. In many cases, buyer generally reply back a counter-offer consisting of a required price differential with new negotiable terms. That’s not an ‘Acceptance’. Under tender rules, seller finally send a confirmation to winning offerer in accordance with mutually negotiated offer19 .

Ultimately, parties agree on an email recap setting out the terms. Recap is a common practice relating to formation of the contracts in oil trade business. It is an obvious recognition that key terms of the contract, set out in that recap, are concluded. This process ends up seller’s sending the sales contract that should be arranged in accordance with the agreed recap terms. As is common for such contracts of sale of goods when a conflict can lead to a contractual dispute, the judge will directly look at the express terms, forming the recap content.

Terms or clauses are the contents of a contract. It is quite routine for oil trading to have a standard form written terms which cannot be quite lengthy. The reason is that General Terms & Conditions for Sales & Purchases of Crude Oil (GTCs), providing a commonly known, commercially neutral set of terms are usually incorporated into all sales contracts with the seller. Of course, contractual parties may use it on a voluntarily basis for reducing negotiation time in each individual deals.

Let’s look briefly to GTCs. GTCs are a set of standardized contract terms that can reflect the changes periodically in market practices. It can be either for crude oil or for petroleum products. In Oil GTCs, separate parts have been introduced as subsections under free on board (FOB), cost, insurance and freight (CIF), cost and freight (CFR) and delivered ex-ship (DES) deliveries20 . The scope contains key terms such as operational procedures, payment, events of default, termination, dispute resolution and time limit for claims. Needless to say, in the event of any inconsistency between the GTCs and the terms of sales contract, the terms of the contract shall always prevail21 .

In line with above explanations, oil sales contract should also include various significant terms that forms the subject matter of the sales contract. In a typical crude oil sales contract, the following terms, given in detail shall define the specified crude cargo of the Seller.

In ‘Quantity & Quality and Determination of Quality’ clause, cargo will be defined as a “Nominal Volume” (e.g. 600,000 barrels or 80,000 Mtons, etc.) plus or minus 5% in seller’s or buyer’s operational tolerance of 195 major crude streams or blends of the quality available at the loading terminal at the time of loading. The operational tolerance shall be arranged with respect to the crude level in loading terminal, seller’s lifting entitlement, buyer’s requirement and/or cargo intake capacity of vessel. Contractual specifications, dealing with the oil’s quality not its description, frequently vary from the final delivered specifications in crude blends. In quality clause, parties, therefore shall agree on an “Independent Inspector” to sample and test the oil to define typical specification. Quality should reference to this sample as a final and binding test result. Unlike products, typical specs, not much wider in variety, are the API gravity, water, sediment and Sulphur content. However, for any brand new oil grades or due to the uncertain quality of oil, the Seller shall give warranty to supply the same quality crude as appreciably no worse than the specifications, tested by independent inspectors and attached to sales contract22 .

According to ‘Delivery & Laytime’ clause, delivery type (e.g. FOB, CIF, etc.) shall be identified under INCOTERMS rules. In this respect, seller undertakes to deliver and buyer undertakes to receive one separate full cargo lot delivered agreed delivery type at one safe and always accessible port or berth during the agreed delivery dates. Moreover, the declared laycan23 by Buyer or Loading terminal shall be included. It is important to note that Seller should provide the ‘Berthing restrictions’ in either the ITT document or the contract. Seller shall be allowed laytime, a period of time agreed between parties during which the owner will keep the vessel available for loading or discharging without payment24 . If the vessel exceeds the agreed laytime, buyer has an independent obligation to pay for demurrage incurred at the loading port after deduction of laytime allowed.

In ‘Payment & Financial Security’ clause, payment should generally be done 30 days from the bill of lading (B/L) issuing date pursuant to the industry practice. However, payment date should be negotiated to shorten for earlier cash flow. Generally, irrevocable documentary or stand-by letter of credit (L/C) is required of the Buyer. Two-point call for special attention: To meet the seller’s requirement it should be both in a form acceptable to seller and issued by the buyer no later than 3 or 5 days prior to the first day of the agreed loading window. If buyer’s L/C is not opened until the loading dates, seller has right to reject the commencement of loading crude oil to vessel even berthing at the terminal. Needless to say, the buyer shall indemnify seller for any losses, damages and especially costs imposed by loading terminal. After loading operation finished, payment would be made against the presentation of certain documents including copy of the signed & stamped invoice evidencing the value of the crude cargo delivered and an original certified B/L documents25 .

Of course, in each and every oil sales contract there have been several differences in accordance with the risk attributable to the transaction and operation.