Throughput contracts allow two or more parties to set forth terms and conditions for the purchase of commodities and goods for long-term projects.
These contracts set the conditions for the minimum order quantity, shipping schedule, and duration of the contract for scheduled deliveries until the contract expires.
Let us discuss what is a throughput contract, a take-or-pay contract, and what are the key differences between these two.
What is a Throughput Contract?
A throughput contract is a form of unconditional contract where one party secures the supply of goods or services for a specified period from the second party.
A throughput contract is arranged by two parties for long-term projects usually. The buyer secures the supply of goods at favorable prices without worrying about the changing costs.
Similarly, the seller can secure long-term sales using a throughput contract. Thus, an unconditional form of agreement benefits both parties in arranging long-term trade contracts.
How Does a Throughput Contract Work?
Throughput contracts are arranged with securing the supply of goods/services in mind. Therefore, the primary objective of the arrangement is to bind both parties to their commitments.
Both parties define the terms and conditions of a throughput contract first. The foremost is to define the price, quantity, and duration of the contract.
The details would also include the shipping and transportation means of the goods. For instance, the seller of goods may also be the shipper of the goods so it would include further clarification of the total prices.
Once both parties agree on the terms and conditions of the throughput agreement, they are not changed and become obligations for both parties.
In many cases, throughput contracts require using specific transportation and shipping facilities. These are often arranged for specific projects as well. It means one party will be taking the risk of producing the goods specifically for the second one.
So, for throughput contracts, even if the buyer does not require the purchased quantity in the future, they would need to pay for that. The prime reason for that is the producer would specifically produce goods/services to oblige the terms of the throughput contract only.
Where are Throughput Contracts Used?
Throughput contracts are usually used in the drilling and oil & gas sectors. One party would secure the rights of exploration of oil and gas in a specific region and would like to secure a long-term contract from a buyer.
In other cases, a shipper would offer shipping facilities through a pipeline, cargo, or road freight from the exploration site to the shipping site.
For instance, a shipper may install a gas pipeline to ship the extracted gas reserves from the site to the refinery site. The buyer may secure rights of using the installed pipeline for a specified period using a throughput contract.
Both sides can agree to set scheduled payments and delivery terms during the contract period. It means even if the buyer does not require specific quantities of the purchased product/commodity, the seller would still get paid.
Example of a Throughput Contract
Suppose a company ABC purchases oil from another company XYZ. Both parties arrange a throughput contract to utilize the pipeline facility set up by XYZ for 10 years.
The contract stipulates a monthly 1 million barrels of oil export from XYZ pipelines to the ABC refinery facility.
ABC agrees to pay $ 300 million of debt used to build the pipeline facility on top of the prevailing oil prices.
For the first year, ABC estimates a yearly payment of $ 15 million for ten years.
Therefore, ABC company will record the $15 million per year costs in accounts for the next 10 years. Even if the facility offered by XYZ is not used for the full year, ABC company will pay the same annual charges.
Accounting Considerations for Throughput Contracts
ASC 440 guides on the accounting consideration of uncertain obligations like a throughput contract.
A company should disclose in notes about throughput contracts and other unconditional commitments. It means such arrangements require disclosure in the financial statements only.
ASC 330 requires companies to recognize and report gains and losses on lease agreements with uncertain conditions. Therefore, some of these throughput contracts would be recorded in the financial statements of a company and others will only require disclosure in the financial statements in the notes section.
What are Take-or-Pay Contracts?
A take-or-pay contract (TOP) is an agreement between two or more parties when the buyer must pay the seller a minimum amount against the purchased goods/services.
These contracts include a clause that binds the buyer to either take and pay for the goods/commodities from the seller or forego the delivery and make a payment to the seller.
Either way, the seller is secured by receiving the payment from the buyer. Therefore, these arrangements are termed take-or-pay contracts.
Unlike the common notion, a take-or-pay contract allows buyers some flexibility as well. For instance, if the buyer does not take the delivery of goods or commodities as agreed upon by both parties, it may not be counted as a breach of the contract.
In other words, a buyer can simply compare the prices of buying at new rates and the original rates stipulated in the TOP contract. Most often, these decisions include shipping costs and other logistic considerations for buyers.
How do Take-or-Pay Contracts Work?
A take-or-pay agreements work similarly to a throughput contract. In practice, there is little that differentiates both types of contracts.
Both parties agree on the commodity/goods prices, payment schedule, shipping method, and duration of the contract.
The take-or-pay contract includes the important clause that allows the buyer:
- Receive the minimum commodity/goods for each shipping schedule and pay accordingly, or
- Pay the seller for the required quantity without receiving it
In most take-or-pay agreements, the selling quantity is not fixed. These contracts are often made for unconditional purchase obligations that allow buyers to receive fluctuating quantities throughout the contract term.
The buyer would not need to make a payment to the seller if:
- The seller failed to deliver the required quantity in a given period.
- The delivered quantity was rejected by the buyer due to quality issues.
- The buyer could not receive the quantity due to external factors affecting both parties.
Disputes in Throughput and Take-or-Pay Contracts
As mentioned earlier, if a buyer refuses to take the scheduled delivery in a take-or-pay contract, it is not considered a breach of contract.
However, in some cases, there can be disputes between the two parties due to the conflicting nature of these contracts.
In most cases, the take-or-pay clause is unenforceable as argued by many buyers. It means the buyer can decide not to take the scheduled quantity and wait until the end of the scheduled period (often until the year-end).
The sellers may not receive any payments that may hamper their sales forecasts. The sellers may not force any payments from the buyer in such cases.
Another dispute arises when these contracts require a seller to ship/transport or make available the goods under the contract terms.
A seller may not be able to ship the goods if the buyer does not hold any facilities to receive the goods. For instance, a buyer must outsource or arrange the shipping of LNG through vessels or pipelines for specified shipping routes.
Throughput Vs Take-or-Pay Contracts
Throughput and take-or-pay contracts are similar in nature. However, both work differently and for different purposes.
A take-or-pay (TOP) contract is often arranged for buying commodities produced and products manufactured. For example, in the oil and gas industry for the purchase contracts of buying oil or LNG by one party from another.
Throughput contracts are often arranged for processing or shipping the commodities. For example, shipping the same LNG secured through a TOP contract from the seller’s place to the buyer’s destination.
Also, a throughput contract would require a minimum payment from the buyer even if it does not purchase the produced goods.
Contrarily, the buyer in the TOP contract can decide to receive the goods or pay the buyer without receiving the scheduled quantity. In such cases, the undelivered quantity would be withheld by the seller until the end of the contract period.
Take-and-Pay Contracts Vs Throughput Contracts
A variation of the throughput and the take-or-pay (TOP) contracts is the take-and-pay (TAP) agreements.
In take-and-pay contracts, the buyer must receive the goods/commodities and make the payment for the minimum quantity as decided in the payment terms for the contract every year.
It means a buyer cannot simply refuse to purchase the minimum order quantity at any given time. Therefore, unlike in a TOP contract, a refusal to receive the ordered quantity would be considered a breach of the contract under the take-and-pay clause.
Also, each time the buyer fails to accept the delivery, it would be considered a separate breach of contract.
