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In brief - Repercussions of gas explosion on Varanus Island severely test contract risk allocations

On 3 June 2008 there was a massive explosion at a gas plant operated by Apache Energy Limited on Varanus Island, off the coast of Western Australia. The explosion caused the cessation of gas production at the plant and resulted in a temporary reduction in the supply of natural gas to the Western Australian market by 30 to 35 per cent. The consequences of that event were far reaching. They affected commerce and relationships in unexpected ways and severely tested contract risk allocations. One such test has found its way to the High Court.

The decision is particularly notable for the way it deals with the tension between a "reasonable endeavours" obligation and the commercial interests of the promisor.

Gas supply agreement between electricity company and various gas suppliers in WA

Electricity Generation Corporation trading as Verve Energy ("Verve") entered into a long term gas supply agreement ("GSA") with various gas suppliers in Western Australia including Woodside Energy Ltd ("Sellers"). Verve is the major generator and supplier of electricity to a large area in the southwest of Western Australia, including Perth. Verve purchases natural gas under the GSA for use in its power stations.

Separate contracts between Verve and each of the Sellers are contained in the GSA, which obliges each Seller to make available for delivery to Verve a proportionate share of a maximum daily quantity of gas ("MDQ"), and to use "reasonable endeavours" to make available to Verve a supplemental maximum daily quantity of gas ("supplementary gas").

Market price of gas increases dramatically following Varanus explosion

Following the gas explosion, many other customers in Western Australia sought to purchase gas from the Sellers, at prices far exceeding those contained in the GSA.

On 4 June 2008, the Sellers informed Verve that they would not supply supplementary gas under the GSA to Verve for an indefinite period. On the same day, the Sellers offered to supply Verve with an equivalent quantity of gas for the month of June 2008 at a significantly higher price.

Under protest, Verve entered into a short term agreement with the Sellers and Japan Australia LNG (MIMI) Pty Ltd ("MIMI") for the supply of daily quantities of gas between 4 June and 30 June 2008. It was common ground that the effect of this new agreement was that the Sellers were under no obligation to supply any particular quantities of gas to Verve, and that the price for gas delivered under the agreement was the prevailing market price.

On 20 June 2008, when it was clear that the shortage of supply created by the Apache incident would continue until the end of September, the Sellers' agent informed Verve that Verve would not receive supplementary gas for the period from 30 June to 30 September 2008.

Again under protest, Verve submitted a successful tender and entered into another gas supply agreement with the Sellers and MIMI, until the end of September 2008. The price for gas delivered under the agreement was the prevailing market price. It was common ground that the Sellers had the capacity to supply supplementary gas during the relevant period.

Electricity company launches legal action against gas suppliers for breach of supply agreement

In March 2009, Verve commenced proceedings in the Supreme Court of Western Australia, arguing, amongst other things, that the Sellers had breached their obligation under the GSA by failing to use reasonable endeavours to deliver nominated supplementary gas to Verve between 4 June and 30 September 2008.

Obligation under contract to "use reasonable endeavours" to supply supplementary gas

Clause 3.2(a) of the GSA required the Sellers to make available for delivery on any day gas up to MDQ, subject to clause 9. Clause 9 stated that Verve must nominate the quantity of gas which it required for the next seven day period and that, within a few hours of nomination, the Sellers had to notify Verve of the quantity to be made available for that period. Under clause 9.3, if Verve's daily nomination exceeded MDQ, each Seller had to use reasonable endeavours to make available for delivery up to an additional 30TJ/Day of gas in excess of MDQ.

Relevantly, clause 3.3(b) stated: "In determining whether they are able to supply [supplementary gas] on a Day, the Sellers may take into account all relevant commercial, economic and operational matters and, without limiting those matters".

The crucial issue of construction is the relationship between the Sellers' obligation to "use reasonable endeavours" to make supplementary gas available for delivery to Verve, and the Sellers' entitlement under clause 3.3(b), in determining whether they "are able to supply [supplementary gas]" on any particular day, to "take into account all relevant commercial, economic and operational matters".

First instance decision: gas suppliers could take profitability and other potential sales into account

At trial Verve contended that clause 3.3(b) gave further content to the Sellers' obligation to use reasonable endeavours to deliver supplementary gas, by providing that "relevant commercial, economic and operational matters" could be taken into account by the Sellers in determining whether they were "able" to supply supplementary gas under the GSA. That is, whether the Sellers had the capacity to supply supplementary gas and not whether they wished to do so.

The trial judge, Le Miere J, found that clause 3.3(b) "conditioned" the Sellers' obligation, by prescribing the circumstances in which the Sellers were not obliged "to use reasonable endeavours" to make supplementary gas available for delivery. His Honour held that commercial matters in the context of clause 3.3(b) included the sale of gas to other customers or potential customers and the profitability of such sales compared with the profitability of supplying supplementary gas under the GSA. He held that clause 3.3(b) entitled the Sellers to take such matters into consideration in determining whether they are "able to supply [supplementary gas] on a Day".

Court of Appeal determines that gas suppliers breached their obligations under supply agreement

The Court of Appeal found that the obligation to use reasonable endeavours was only a set of factors that the Sellers could take into account to inform their obligation to supply supplementary gas. Murphy JA held that there was nothing in clause 3.3 that gave the Sellers a right to decide whether or not to supply supplementary gas, other than their obligation to use reasonable endeavours once a nomination under clause 9 had been made.

Accordingly, the Court of Appeal found that the trial judge erred and that the word "able" referred to the Sellers' capacity to supply the supplementary gas. The Court of Appeal found that the Sellers were in a position to supply gas to Verve during the relevant period and that as a result, they had breached their obligation to supply gas under the GSA.

High Court overturns Court of Appeal decision; first instance decision reinstated

By special leave, both parties appealed to the High Court of Australia. In Electricity Generation Corporation t/as Verve Energy v Woodside Energy Ltd & Ors; Woodside Energy Ltd & Ors v Electricity Generation Corporation t/as Verve Energy [2014] HCA 7, the majority of the High Court found that the Sellers did not breach their reasonable endeavours obligation to make available supplementary gas and that the decision of the trial judge, Le Miere J, was to be accepted.

In essence, Verve contended in the High Court that the Sellers breached their obligation to use reasonable endeavours to supply supplementary gas to Verve, notwithstanding the circumstance that the prevailing market price of gas was significantly higher than the price of supplementary gas under the GSA.

How commercial contracts are to be construed

In considering the matter, the High Court re-affirmed that the following principles are to be adopted in determining the rights and liabilities of parties to a contract:

• The meaning of the terms of a commercial contract is to be determined by what a reasonable businessperson would have understood those terms to mean.

• It requires consideration of the language used by the parties, the surrounding circumstances known to them and the commercial purpose or objects to be secured by the contract.

• An appreciation of the commercial purpose or objects is facilitated by an understanding of the genesis of the transaction, the background, the context and the market in which the parties are operating.

• A commercial contract is to be construed so as to avoid it making commercial nonsense or working commercial inconvenience.

Contractual obligation to use reasonable endeavours

The High Court also made three general observations about obligations to use reasonable endeavours to achieve a contractual object:

• It is not an absolute or unconditional obligation.

• The nature and extent of an obligation imposed is conditioned by what is reasonable in the circumstances, which can include circumstances that may affect an obligee's business.

• Some contracts that contain this obligation also contain their own standard of what is reasonable, by some express reference relevant to the business interests of an obligee.

Gas suppliers not obliged to sacrifice their own business interests when using reasonable endeavours

Based on those principles and authorities, the High Court found that the GSA, pre-eminently a commercial contract between parties at arm's length with their own independent business interests, should be given a businesslike interpretation.

The High Court found that the Sellers have an unconditional obligation to supply MDQ, but a conditional obligation to supply supplementary gas, the condition being that the Sellers are entitled to take into account "relevant commercial, economic and operational matters" when determining whether they are "able" to supply supplementary gas.

Their Honours observed that the term "commercial, economic and operational matters" refers to matters affecting the Sellers' business interests. The effect is that the Sellers are not obliged to forgo or sacrifice their business interests when using reasonable endeavours to make supplementary gas available for delivery.

The word "able" in clause 3.3(b) relates to the Sellers' ability, having regard to their capacity and their business interests, to supply supplementary gas. Thus, based on that interpretation of clause 3.3, the Sellers were not obliged to supply supplementary gas to Verve when the Apache incident occasioned business conditions leading to conflict between the Sellers' business interests and Verve's interest in obtaining nominated supplementary gas.

Subsequent decisions guided by High Court's decision in Woodside case

Since this decision was handed down on 5 March 2014, both the NSW Supreme Court and the Victorian Supreme Court have looked to it for guidance. Three examples include:

• When faced with two possible interpretations of a contractual clause, the NSW Court of Appeal, in Neale v Ancher Mortlock & Woolley Pty Ltd [2014] NSWCA 72, applied the approach of the High Court and adopted an objective approach in determining the proper construction of the contact (at [94]).

• In Fu v Bucasia Pty Ltd [2014] NSWSC 325, the NSW Supreme Court was guided by the High Court and interpreted the contractual terms by considering how the reasonable businessperson would have understood the terms.

• In Metier3 Pty Ltd v Enwerd Pty Ltd & Anor [2014] VSC 80 the Victorian Supreme Court followed the High Court approach by construing the terms of a Deed of Settlement based on what a reasonable businessperson would have understood the terms to mean.

"Reasonable endeavours" clauses need to be carefully drafted

This case reaffirms principles that the courts look at in determining the rights and liabilities of parties to a contract.

• It illustrates that "reasonable endeavour" clauses need to be carefully drafted and, where possible, include express and specific restrictions.

• In a broader sense it establishes that an obligation to use reasonable endeavours may give the promisor discretion not to fulfil its obligation solely due to a change in market circumstances. The promisor was entitled to charge a higher price and was not obliged to sacrifice its business interests to comply with the reasonable endeavours obligation.

• It highlights the importance of considering scenarios that may affect the promisor's business and thereby diminish its responsibility to comply with the contract.

This article has been published by Colin Biggers & Paisley for information and education purposes only and is a general summary of the topic(s) presented. This article is not specific legal advice. Please seek your own legal advice for any questions you may have. All information contained in this article is subject to change. Colin Biggers & Paisley cannot be held responsible for any liability whatsoever, or for any loss howsoever arising from any reliance upon the contents of this article.​

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