Article

Contractual commitments and consequences for petrochemical business interruption losses

March 13, 2020 · Authored by Clive Burrows, Justin Crick

Introduction
Following an incident, an Insured party may be restricted by the conditions of the contract, which could significantly impact the business interruption loss, due to the effect on (i) the costs of raw material / feedstock or (ii) sales of final products to the business. However, the policy language does not always take into account the contractual commitments. 

Feedstock / Raw Material Commitments
There are various contracts available on the “buy” side, however two common forms are:

1. Take-or-Pay-Contracts – these are longer term commitments (typically 1 to 5 years) where the buyer must pay the contracted price even if the minimum volume of feedstock is not taken;
2. Rolling Order Contracts – this is where the quantity supplied is set out over a defined rolling period with a shorter-term commitment, for instance 3 months.

If the minimum orders are not taken, it could result in additional costs to the buyer particularly if the clause restricts the buyer’s ability to consume the product at alternative locations or sell the product to a third party. The basis of the costs depends on the conditions of the contract and could be in the form of:

• Value of sales shortfall against the commitment – this is where a seller has the right to sell the volume in question to another entity at market price, with any value lost being passed on to the buyer. These costs could be significant especially if the contract price does not take account of changes in prices, such as the drop in oil or natural gas prices in 2015;
• Cost of distressed sale incurred by the seller (i.e. the lost sales value and additional selling costs in a third party sale);
• Percentage of the minimum volume.

These costs may be avoided if there is a make-up clause allowing catch-up in later months, or if a Force Majeure Clause is triggered.

In the event of an insured incident which results in lower feedstock requirements, and if the contractual commitments cannot be avoided, it is not uncommon for the loss to form part of a Business Interruption claim, which can be substantial, as set out in the example below: