TITLE TROUBLES COMMINGLED AND BLENDED PETROLEUM

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1 TITLE TROUBLES COMMINGLED AND BLENDED PETROLEUM by Angela Wallace, Trainee Solicitor Introduction The transfer of title in petroleum products may not always be as straightforward as a supplier and buyer might hope. Petroleum is fungible in nature, and so can be freely mixed with other products possessing the same characteristics, with the result that it is not possible to distinguish the original components within the greater whole. The legal treatment of mixed petroleum products belonging to two or more individuals is always an issue when gas is transported in a multi-shipper pipeline, but is also relevant in LNG trading and gas storage. Express contractual provision can be made for situations in which petroleum is mixed with third-party stocks (whether intentionally or otherwise), but where a transaction involves the buying or selling of part of a larger bulk of goods and that bulk consists of mixed goods owned by multiple parties, the various ownership claims to those goods may not always be clear, despite what has been agreed between the parties. The legal treatment of mixed petroleum products belonging to two or more individuals is always an issue when gas is transported in a multi-shipper pipeline, but is also relevant in LNG trading and gas storage This article will consider how English law rules relating to title transfer have distinguished between commingled and blended petroleum quantities. It will go on to consider how terms implied by the Sale of Goods Act 1979 (as amended) ( the 1979 Act ) apply to petroleum supply contracts, as well as in the context of underground gas storage. Ownership of mixed goods The difficulties that can arise with multiple ownership claims over mixed fungible goods were first contemplated under Roman law. The doctrine of confusio concerned the mixing of liquids, which by their nature could not be readily separated after mixing (thereby preventing identification of the original constituent parts of the greater whole). On the basis that separation of the original goods was impossible, cases of confusio were deemed to give rise to co-ownership of the mixed bulk. This applied, for example, to wine. By contrast, commixtio concerned the mixing of solids, which were capable of retaining their physical identities after mixing. This characteristic allowed them to be physically separated and returned to their original owners. This applied, for example, to grain. In The Ypatianna 1, the mixing of crude oil was held to be a case of confusio on the basis that, for practical purposes, the mixture could not be separated. Other matters that have been considered in relevant case law include whether a distinction should be drawn between consensual (i.e. expressly authorised under the supply contract) or accidental and non-consensual mixing. This distinction aimed to penalise the party responsible for the wrongful mixing and to protect the innocent party 2, and to this end the English courts have indicated that any doubt as to the quantity of a party s goods is likely to be resolved in favour of the innocent party. Additionally, where the respective contributions cannot be determined, the court may order that the entire bulk is to be held in equal shares 3,

2 as opposed to the less equitable alternative of ordering that ownership of the entire bulk rests with the supplier (which is unlikely to give effect to the parties commercial objectives). These early distinctions have helped to shape the legal position in relation to mixed goods today. Separability is no longer considered the deciding factor in determining title to mixed goods (as was applied under Roman law). Rather, what must be determined is whether the respective contributions of multiple owners of a mixed bulk can be identified. what must be determined is whether the respective contributions of multiple owners of a mixed bulk can be identified Commingled and blended goods Transfer of title rules under English law differ depending on the manner and extent to which goods belonging to two or more persons are mixed together. Case law has drawn a distinction between the mixing of goods falling within the following categories: commingled goods involves the mixing of homogenous goods, which maintain their identity after mixing. The specific goods themselves remain unaltered but it is impossible to identify the precise components within the greater bulk; and conditions, and any breach will give the buyer a right to reject the goods, terminate the contract and/or claim damages. Unascertained goods Of particular significance in the context of petroleum supply is S. 16 of the 1979 Act, which deals with the transfer of ownership in unascertained goods. The 1979 Act draws a notable distinction between specific or ascertained goods, which are defined as goods identified and agreed on at the time a contract of sale is made (S. 61), and those goods which do not satisfy this definition. The distinction fundamentally hinges on identification. Logically, where any particular component of a greater bulk cannot be identified with certainty, an assertion of a proprietary interest in that component is impossible. Under S. 16, title to unascertained goods will therefore not pass to the buyer until those goods have become ascertained. Case law has further suggested that ascertainment will only occur when the specific goods which are the subject matter of the contract are unconditionally separated and identifiable from the larger bulk. Retention of title to mixed goods In theory, retention of title clauses afford a seller contractual protection in the event of a buyer s insolvency by allowing an unpaid seller to claim ownership of, and retake, the goods supplied (and which have not been paid for) ahead of the buyer s other creditors. In practice however, the position of an unpaid seller is a precarious one, particularly where his counterparty has fallen into financial difficulty. Where the supplier has reserved title to petroleum products which have been mixed with stocks belonging to different owners, the rule under S. 16 can prove problematic. Ordinarily, the 1979 Act permits suppliers to retain ownership of goods supplied until certain conditions (as may be imposed by the supplier) are satisfied; commonly, until payment is made in full by the buyer (S. 19). Only upon the satisfaction of such conditions will title pass to the buyer. However, in Re CKE Engineering Ltd (in administration) 4, in which molten zinc ingots supplied by CKE (and subject to a retention of title clause) were mixed with zinc ingots from other sources and of possibly different grades, it was held that it is not possible to retain title in something that cannot sensibly be identified. blended goods involves the mixing of heterogeneous goods, which essentially lose their identity in the mixing process. For example, raw materials which are used in a manufacturing process are often irreversibly combined to create a new product. The common law position in respect of the transfer of title in mixed goods has been codified in the 1979 Act. A quick recap of implied terms Where a supplier sells goods in the course of business, the 1979 Act will operate to fill in any gaps in the contract. The terms implied in most sales contracts are contained in sections 12 to 15 of the 1979 Act, and these relate to title, conformance with description or sample, quality and fitness for purpose. These terms are Issue 14 June 2015 andrewskurth.com

3 Division of mixed goods Under the common law, cases of commingling have resulted in the mixed bulk being held by all the contributing owners as tenants in common, which is more forgiving than the statutory provision (since, under S. 16 of the 1979 Act, title to any part of the commingled stock will not pass to the buyer on the basis that the goods have not been physically ascertained). In The Ypatianna 5, a quantity of Russian crude oil being transported on a vessel was mixed with crude oil already on board the vessel belonging to the shipowners. The resultant mixture could not be separated, and the applicant claimed delivery of the entire mixture. It was held that the parties respective contributions to the mixed whole could be sufficiently determined (despite having not been strictly ascertained at that point in time), and therefore that the owners held the commingled stock as tenants in common in proportion to their contributions. It would appear that the only qualification to this approach is that the respective shares of each tenant in common must be, and must remain, ascertainable throughout the duration of the tenancy in common. (iii) the buyer has paid for some or all of the goods forming part of the bulk. Provided these three conditions are satisfied, property in any part of the commingled bulk will transfer to the buyer, and the buyer will become an owner in common of the bulk. It should be noted that under S. 20B, a person who has become an owner in common under S. 20A is deemed to consent to dealings with the bulk by any other co-owner in common. Gas storage title issues Shares of gas stored in gas storage facilities (other than in segregated storage) will always constitute unascertained goods, by virtue of having been mixed with stocks owned by multiple parties. An analysis of the legal implications of transferring title to gas in store may help to demonstrate some of the practical issues that can arise when dealing with commingled goods. Gas held in a gas storage facility will consist of: (i) cushion gas, which remains in the facility at all times and is essential for the maintenance of a minimum storage pressure necessary for the injection and withdrawal of gas; and (ii) working gas, as the flexible gas volumes that can be injected and stored or withdrawn at any time. Some underground storage facilities will also contain native gas originally in the reservoir. Transfer of property in part of a commingled bulk The strict application of S. 16 would make it impossible for a seller to transfer its share of a commingled bulk to a third party. However, amendments made to the 1979 Act have served to mitigate the harshness of S. 16. S. 20A (inserted by the Sale of Goods Act 1995) makes express provision for the treatment of undivided shares in goods forming part of a bulk, and qualifies the application of S. 16 (although only from the buyer s perspective) in the following circumstances: (i) where there is a sales contract for a specified quantity of unascertained goods; and Usually, the agreement between the facility owner and the facility user will provide that the user retains title to its gas while the gas is in store, or that title transfers to the facility owner at the point of injection and then back to the user at the point of redelivery. In either case, the facility owner will have a form of stock accounting system in place for recording the volumes contributed by each user, and this will be updated any time there is an injection into or withdrawal of gas from the facility. The latter approach (whereby a facility owner takes title to all gas in store) is likely to be desirable for the facility owner, who will have the ability to manage all the gas in store, with the users having the power to exercise their drawing rights in respect of the gas by making nominations to this effect. Commingling will not be an issue in these circumstances, as the facility owner will be the sole owner of the entire bulk. (ii) the goods form part of a bulk identified by the parties (in the contract or by subsequent agreement); and (crucially)

4 However, where the users of a gas storage facility have elected to retain title to their respective shares of the gas in store, the rules relating to commingled goods must be considered. S. 20A will only apply in limited circumstances in the gas storage context, and includes a situation in which a tenant in common wishes to sell part or all of its share to a third party. S. 20A can operate to allow the transfer of title in respect of that user s undivided share to the buyer, despite such share being unascertained. However, the transfer of title will occur only as and when the buyer has made payment for that part. Blended goods For completeness, this article will briefly consider the legal treatment of blended goods. In contrast to the position in respect of commingled goods, where goods supplied under a retention of title clause are subsequently mixed with other heterogeneous goods by the buyer, and this mixing results in the irrevocable physical alteration of the original goods supplied or in the formation of an entirely new product, title to the resultant blended goods will typically vest in the buyer (subject to any express agreement to the contrary 6 ). The logic behind this approach is that the original goods no longer exist as they cannot meaningfully be identified within the resultant product, and therefore any proprietary claim in respect of those goods falls away. In Borden (UK) Ltd v Scottish Timber Products Ltd 7, which involved the supply of resin that was used in the manufacture of chipboard (before the resin had been paid for), it was found that the resin had lost its identity in the manufacturing process and could not be traced into the resultant chipboard. Consequently, the supplier was prevented from claiming a proprietary interest in the insolvent buyer s manufactured product. This result was said to avoid a situation in which a supplier benefitted from an unmerited windfall were he to gain title to the manufactured goods, when in fact he had only reserved title to the raw materials supplied. If it is likely that the goods supplied will be used in a manufacturing process, the supplier could seek to expressly reserve full title to the manufactured goods (through what is commonly known as a mixed goods clause). This does not preclude the supplier from also including a retention of title clause in respect of the raw goods supplied, and a combination of the two will theoretically ensure the supplier is fully protected against the buyer s insolvency. However, it is unclear whether such a clause will be effective or whether the courts will declare the supplier s interest in the manufactured goods to be a charge, which will be void against a liquidator or administrator unless registered. The fine line between commingling and blending Returning to gas storage, a user of a storage facility will be concerned to ensure that the gas that it injects into the facility maintains its original quality and value. The gas will be analysed prior to injection to ensure that it is on-spec 8. Where the shares to the commingled gas stock in storage are held by the various owners as tenants in common and where any user wishes to sell all or a part of its share to a third party, a retention of title clause within the sales contract could be invalidated if the introduction of off-specification gas results in an entirely new product being created. Issue 14 June 2015 andrewskurth.com

5 In practice, it may not always be easy to determine whether the original goods have been fundamentally altered to the extent that a new product has been created, and the original goods no longer exist. Therefore, at what point blending will take place rather than commingling may not be clear cut, and will need to be determined on a case-by-case basis. In Glencore International AG v Metro Trading International Inc (No 2) 9, the court stated that the essential distinction between blending and commingling is that where blending has taken place the resultant product is different in nature from both its original constituents ; but also recognised the difficulties that could arise where blending was unauthorised or inadvertent. This may also create practical issues for the existing users, including the possible reduction in the value of the entire volume of gas, and (among other consequences) the potential for on-sale contracts (in which a certain specification has been agreed in advance) to be invalidated. The owner(s) of the contaminated volumes could consequently be put to the expense of having to find alternative buyers for the altered product 10. Conclusion Where petroleum stocks have been commingled and it is possible to calculate the respective shares of the owners of the mixed bulk, the suppliers will retain title to their shares and there will be a tenancy in common of the bulk in those proportions. Where petroleum stocks have been blended, the supplier will (generally) be prevented from making a proprietary claim in respect of the new fundamentally altered product, in respect of which, title will vest in the buyer. However, some cases will straddle this distinction (for example, where off-specification gas is introduced), and it is in such situations that a retention of title clause may not give the supplier the protection envisioned. A mixed goods clause purporting to retain title over the manufactured goods should be treated with caution, on the basis that the supplier s interest in the manufactured goods could be held to be a charge and therefore void unless registered. In the context of petroleum storage, facility owners and their users should ensure that they have in place an agreement clearly setting out the parameters for acceptable variances in gas specification (if any), as well as a method for clear stock accounting. 1. Indian Oil Corp Ltd v Greenstone Shipping Co SA (Panama) (The Ypatianna) [1988] Q.B Ibid. 3. Buckley v Gross (1863) 3 B&S [2007] B.C.C Indian Oil Corp Ltd (n 1) 6. In Clough Mill Ltd. v Martin [1985] 1 W.L.R. 111, it was stated that, in principle, there was no reason why the respective owners of raw goods, which had been used in a manufacturing process to create a new product, should not be able to agree where legal title to that new product should lie. 7. [1981] Ch Although not explored in this article (as this is an entire topic in itself), concerns regarding offspecification gas are particularly pertinent where numerous streams of gas are being transported through a multi-shipper pipeline, as there is a higher likelihood that the mixed stream could be inadvertently contaminated. 9. [2001] 1 All E.R. (Comm) This was the result in the Mercini Lady (referenced above at n 5) in which a cargo was on-spec prior to being loaded on a ship for a sea voyage, but was found to be off-spec on delivery due to the introduction of sediment. The buyers on-sale contracts could no longer be honoured. Angela Wallace Trainee Solicitor [email protected] Angela is a trainee solicitor with a keen interest in the energy industry and oil and gas work and she works closely with the transactional team in London. She received her honours degree in law from the University of Bristol, and prior to joining Andrews Kurth she spent two years gaining industry experience.