LETTERS OF CREDIT COVERING OIL
COMMODITY TRANSACTIONS
- SPECIAL FEATURES -
JEREMY
FRANCIS BCom
PGDipCom
A
BANKERS 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 Bankers 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
todays 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 applicants LC will equal to the value of the corresponding LC
from the applicants customer. Sometimes the applicants 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
authors 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.
