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LETTERS OF CREDIT COVERING OIL COMMODITY TRANSACTIONS
- SPECIAL FEATURES -

JEREMY FRANCIS  BCom PGDipCom

 

 A BANKER’S DILEMMA OR TRADE PRACTICALITIES?

Letters of Credit (LCs) – subject to the ICC Uniform Customs and Practice for Documentary Credits, ICC Publication number 500 (UCP500) – that cover purchases of crude oil and/or refined petroleum products (oil), usually contain some peculiarities from a Banker’s point of view.

Having been involved - through an international oil company - as both the beneficiary and applicant under 'oil Letters of Credit', I can agree with this point of view but I would like to explain the reasons for the peculiarities.

Letters of Indemnity for Missing Documents (LoIs):

In today’s trading environment, cargoes of oil can change hands many times, although voyages can often be measured in a few days. Nevertheless documents need to be prepared and physically checked following each ownership transfer. The result of this is cargoes arriving at ports of destination before the documents. A shipowner or carrier is not required to hand over a cargo if the related Bill of Lading is not available. Thus potentially bringing about delays and additional cost. Traders' Letters of Indemnity for Missing Documents (LoIs) have traditionally been used to enable the Carrier to release a cargo to the ultimate receiver/buyer, and to allow payment to be collected for a cargo (by other parties in the related chain of sell/buy transactions) in the absence of the documents required under normal contract payment terms.

An LoI is of course only as reliable as the issuing company. For this reason many companies insist that the document must be countersigned by a bank of acceptable quality. As a general guideline, if a counterparty is one from which we would request an LC - or other payment security if we were selling to them - we would also request them to have any LoIs they issued countersigned by a bank.

The general wording or text of traders’ LoIs is fairly standard – see the example presented below.

Without going into the complexities of the content of LoIs it is true they have potential to create complex legal problems, for example:

·        Often LoIs are not limited in time or value.

·        Problems could arise if, somewhere in a lengthy chain of counterparties, one goes bankrupt after the buyer has paid the price against the LoI ?

·        Often LoIs will state that they are 'automatically cancelled upon tendering of the documents'. If the buyer wishes to make a claim for a document defect, that  only becomes apparent once the documents are delivered, the seller could argue the LoI 'has been terminated'.

LoIs do give rise to concerns among the bankers and traders that use them, the fact remains though that - even with the potential problems - the system has worked well to date. LoIs serve an essential function in the handling of commodity transactions. Rather than creating a financial obligation LoIs give rise to performance obligations, in practice. The latter type of risk can be managed by banks through the tight control of related documents, and an expert knowledge of the counterparties involved in a transaction.

Change is on the way though and new systems such as @GlobalTrade with its 'paperless Bills of Lading' and Bolero.net with its 'central registry' could well spell the end of LoIs. The age of electronic documents is upon us and, although it may be a few years away yet, the instantaneous secure transfer of electronic shipping documents between counterparties will end the need for the issuance of LoIs.

Value Escalation / De-escalation Clauses:

The pricing of oil, as with other commodities, is linked to benchmarks; the two major benchmark prices for crude oil are Dated Brent and WTI (West Texas Intermediate). The volatility and price fluctuations inherent in oil trading mean that contract prices, rather than being fixed, are usually linked to one of these benchmarks. Actual prices being determined on ‘x’ number of days before or after the Bill of Lading date, plus or minus a premium or discount; depending on the supply/demand and specifications of the actual crude being bought and sold.

Oil LCs often have an ‘escalation’ clause because the actual price, and therefore the value of the LC, will not be known until after the Bill of Lading date. LCs are usually opened 5-10 days prior to B/L date, so a bank will often only know its liability under an LC 15-20 days after the LC is opened. This is not inconsistent with UCP600, since these rules do not state that an LC has to be issued for a specific amount. Please refer to supporting legal decisions handed down in Singapore Courts, which would be persuasive in respect of any case brought in the Courts of England.

However an opening bank has to record LCs it issues as contingent liabilities. In order to record a "reasonable" value initially, the bank would normally calculate the value on the day of issuance and then add, say, 10%. The opening bank would then review this calculation periodically to ensure there has not been a dramatic price fluctuation.

It should be noted that a number of the more conservative banks, which do not specialise in oil LCs, will not issue an LC with a price escalation clause. In these cases the seller has to make a judgement as to whether or not an LC is for a sufficient value to cover the transaction, when the LC is received.

In many cases, banks open oil LCs on a 'back to back' basis, that is to say they will open an LC for an applicant, based on the fact that the applicant has already received an LC opened in its favour for the same cargo of oil. In such situations the bank has no price basis risk, provided both LCs contain escalation/de-escalation clauses and refer to the same benchmark price. The value of the applicant’s LC will equal to the value of the corresponding LC from the applicant’s customer. Sometimes the applicant’s buyer provides a "Payment Undertaking" to the bank – instead of an LC – but the reasoning is the same.

The risk for banks inherent in an ‘escalation clause’ is mainly corporate or customer risk. The risk that a applicant will fail to pay either due to financial constraints (bankruptcy) or due to dishonesty (indefinite payment delays without good reason). As with LoIs, banks can manage and hedge this type of risk by having an expert knowledge of the transaction and of the counterparties involved. Obviously banks without any specialist knowledge of the oil industry, and the way in which deals are structured and financed within this industry, should be wary of involving themselves in this type of business.

In summary, banks will only open LCs with 'escalation clauses' for a limited number of  customers, that are experienced in the market. Normally such banks insure that their customers are protected against the 'price basis risk' (the risk that arises if the purchase price fluctuates independent of the way the ultimate selling price fluctuates) by having a matching sales contract, with matching price benchmark and basis terms, with an ultimate buyer of undoubted credit quality.

Conclusion:

Oil Letters of Credit are a specialised area, as a result only a few banks have come to be known as ‘oil banks’, because they have the expertise and experience to manage the irregular risks involved. Any bank that succumbs to the wishes of a beneficiary or applicant by including special 'oil clauses' in an LC, without considering the implications of these wishes and without considering ways of mitigating any extra risk, is treading dangerously.

 

© Copyright 2001  J L Francis

Published with permission.

 

Author Profile:
At  the time of writing this article Jeremy L Francis was based in London, UK, and working as an Associate Credit Specialist - Eastern Hemisphere, for Chevron Corporation (now ChevronTexaco Corporation). Before joining Chevron in 1999, he worked for export trading companies in New Zealand, gaining extensive experience in trade operations, financial analysis, and trade finance. Jeremy has a Bachelor of Commerce and Management degree, with a Post-Graduate Diploma in Commerce, from Lincoln University, New Zealand. He left ChevronTexaco and returned to New Zealand in August 2002. Contact Jeremy via email at: Jeremy Francis (New Zealand).
The views and opinions expressed in this article are the author’s and do not necessarily reflect those of his former employer.

EXAMPLE  LETTER   OF   INDEMNITY  FOR   MISSING  DOCUMENTS:

 

TO:  ( BUYER )

DATE:

RE: SHIPMENT OF ……….. METRIC TONS OF …………………………CRUDE OIL SHIPPED PER MTV ……………. B/L DATED ………….2001, COVERED BY                DOCUMENTARY CREDIT NUMBER …………. OF  ……( DATE )…………...

 

DEAR SIRS,

ALTHOUGH WE, ………………( SELLER )……………………, HAVE SOLD THE ABOVE MENTIONED CARGO TO ………( BUYER )…………………. WE HAVE BEEN UNABLE TO PROVIDE YOU WITH THE ORIGINAL SHIPPING DOCUMENTS INCLUDING 3/3 ORIGINAL CLEAN ON BOARD BILLS OF LADING ISSUED OR ENDORSED TO THE ORDER OF ……( BANK OR BUYER )………………. AS REQUESTED BY DOCUMENTARY CREDIT NUMBER ……….. COVERING THE SAID SALE.

IN CONSIDERATION OF ……………( BANK – IF APPLICABLE ) ………………..FOR ACCOUNT OF……………………( BUYER )……………………………………………, PAYING US THE FULL PURCHASE PRICE OF USDLRS ……………….WE HEREBY TRANSFER TITLE TO YOU AND EXPRESSLY WARRANT THAT WE HAVE MARKETABLE TITLE TO SUCH CARGO FREE AND CLEAR OF ANY LIEN OR ENCUMBRANCE AND THAT WE HAVE FULL RIGHT AND AUTHORITY TO TRANSFER SUCH TITLE AND TO EFFECT DELIVERY OF SUCH MATERIAL TO YOU.

WE FURTHER AGREE TO EXERCISE OUR UTMOST EFFORTS TO LOCATE AND SURRENDER TO …………( BANK OR BUYER ) ……………….FOR ACCOUNT OF ……………(BUYER ) …………………..AS SOON AS POSSIBLE THE ORIGINAL SHIPPING DOCUMENTS INCLUDING 3/3 ORIGINAL CLEAN ON BOARD BILLS OF LADING ISSUED OR ENDORSED TO THE ORDER OF ………( BANK OR BUYER ) ………. AS REQUESTED BY DOCUMENTARY CREDIT NUMBER. …………..  AND TO PROTECT, INDEMNIFY AND SAVE YOU HARMLESS FROM AND AGAINST ANY AND ALL DAMAGES, COSTS, COUNSEL FEES (INCLUDING REASONABLE ATTORNEY FEES) AND ANY OTHER EXPENSES WHICH YOU MAY SUFFER BY REASON OF THE ORIGINAL BILLS OF LADING AND OTHER SHIPPING DOCUMENTS REMAINING OUTSTANDING, INCLUDING, BUT NOT LIMITED TO, ANY CLAIMS AND DEMANDS WHICH MAY BE MADE BY A CONSIGNOR, A HOLDER OR TRANSFEREE OF THE ORIGINAL BILLS OF LADING AND OTHER SHIPPING DOCUMENTS, OR BY ANY OTHER THIRD PARTY CLAIMING AN INTEREST  IN OR LIEN ON THE CARGO OR PROCEEDS THEREOF.

THIS LETTER OF INDEMNITY SHALL BE CONSTRUED, INTERPRETED AND GOVERNED BY THE LAWS OF …( COUNTRY ) ……(WITHOUT LIMITATION AS TO ITS FORM CONTENTS, VALIDITY AND ENFORCEABILITY, BUT WITHOUT REFERENCE TO ANY CONFLICT OF LAW RULES).

THIS LETTER OF INDEMNITY WILL EXPIRE UPON OUR TENDERING TO ……( BANK ) ….. FOR ACCOUNT OF ………( BUYER ) ………, THE ORIGINAL SHIPPING DOCUMENTS INCLUDING 3/3  ORIGINAL CLEAN ON BOARD BILLS OF LADING ISSUED OR ENDORSED TO THE ORDER OF …………( BANK OR BUYER ) ………………… AS REQUESTED BY DOCUMENTARY CREDIT NUMBER ……………………………….. AND ISSUED IN STRICT CONFORMITY WITH SAID DOCUMENTARY CREDIT.

YOURS FAITHFULLY,

……………( SELLER )……………..

 

…………………………

AUTHORIZED SIGNATORY

 

© Copyright 2001  J L Francis

Published with permission.

 
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Last Updated:  January 02, 2017 17:17 -0000