1. 1 George Mason School of Law Contracts I N.Requirements Contracts F.H. Buckley fbuckley@gmu.edu

2. Output and Requirements Contracts: A special case of uncertainty  Vas ist das? UCC § 2-306(1) A term which measures the quantity by the output of the seller or the requirements of the buyer means such actual output or requirements as may occur in good faith, except that no quantity unreasonably disproportionate to any stated estimate or in the absence of a stated estimate to any normal or otherwise comparable prior output or requirements may be tendered or demanded. 2

3. Output and Requirements Contracts  Vas ist das? Output contract: buyer agrees to purchase seller’s entire output 3

4. Output and Requirements Contracts  Vas ist das? Output contract: buyer agrees to purchase seller’s entire output Requirements contract: producer agrees to sell as much of his product as buyer requires 4

5. Output and Requirements Contracts  Why enter into such agreements? 5

6. Output and Requirements Contracts  Why enter into such agreements? Output contract: producer locks in to sale, can safely bulk up on inventory 6

7. Output and Requirements Contracts  Why enter into such agreements? Output contract: producer locks in to sale, can safely bulk up on inventory Requirements contract: buyer assures himself of supply 7

8. Requirements Contracts  Risks to producer? 8

9. Requirements Contracts  Risks to producer What if market price > contract price Market @ 120, contract @100 9

10. Requirements Contracts  Risks to producer:  What if market price > contract price  What if cost of production > contract price Cost @120, contract @100 10

11. Eastern at 317 11

12. Eastern  Requirements contract where Gulf was to supply jet fuel to Eastern 12

13. Eastern  Requirements contract where Gulf was to supply jet fuel to Eastern Price adjustment clause : Gulf to pass on 50% of the increase in West Texas Sour 13

14. So what happened to oil prices in 1974? 14

15. So what happened to oil prices in 1974? 15

16. Eastern Air Lines  August 15, 1971: Nixon announces price controls to combat inflation 16

17. With predictable results… 17 Gas lines at the pump, 1974

18. Eastern Air Lines  August 15, 1971: Nixon announces price controls to combat inflation  June 27, 1972: Contract signed 18

19. Eastern Air Lines  August 15, 1971: Nixon announces price controls to combat inflation  June 27, 1972: Contract signed  Oct. 6, 1973: Yom Kippur War  Oct. 17, 1973: Arab members of OPEC announce an oil embargo on the US  Nov 27, 1973: Emergency Petroleum Allocation Act with two-tier pricing 19

20. Eastern Air Lines  August 15, 1971: Nixon announces price controls to combat inflation  June 27, 1972: Contract signed  Oct. 6, 1973: Yom Kippur War  Oct. 17, 1973: Arab members of OPEC announce an oil embargo on the US  Nov 27, 1973: Emergency Petroleum Allocation Act with two-tier pricing  With the result that prices went up 20

21. 21 Supplier Buyer Requirements Contracts Price fluctuations and Incentives

22. 22 Contract Price > Market Price Supplier Supplier wants to sell as much as he can Buyer Requirements Contracts Price fluctuations and the Incentives of the Parties

23. 23 Contract Price > Market Price Supplier Supplier wants to sell as much as he can Buyer Buyer wants to buy as little as he can Requirements Contracts Price fluctuations and the Incentives of the Parties

24. 24 Contract Price > Market Price Market Price > Contract Price Supplier Buyer Requirements Contracts Price fluctuations and the Incentives of the Parties

25. 25 Contract Price > Market Price Market Price > Contract Price Supplier Supplier wants to sell as little as he can Buyer Requirements Contracts Price fluctuations and the Incentives of the Parties

26. 26 Contract Price > Market Price Market Price > Contract Price Supplier Supplier wants to sell as little as he can Buyer Buyer wants to buy as much as he can Requirements Contracts Price fluctuations and the Incentives of the Parties

27. 27 Contract Price > Market Price Market Price > Contract Price SupplierGulf wants out Buyer Eastern wants to enforce contract Requirements Contracts Price fluctuations and the Incentives of the Parties

28. Eastern Air Lines  So why didn’t the price adjustment clause cover the increase? 28

29. Eastern Air Lines  So why didn’t the price adjustment clause cover the increase? Based on West Texas Sour (domestic) The Nixon administration imposed price controls, fixing the price of old oil and permitting higher prices only to the extent that new oil was produced. 29

30. Eastern  Wouldn’t it have been simpler to base the price on Gulf’s costs? 30

31. Eastern Air Lines  What is the uncertainty problem? And how did courts handle it before UCC 2-306? 31

32. Eastern Air Lines  What is the uncertainty problem? And how do courts handle it under UCC 2-306?  “except that no quantity unreasonably disproportionate to any stated estimate or in the absence of a stated estimate to any normal or otherwise comparable prior output or requirements may be tendered or demanded” 32

33. Eastern Air Lines  What is the uncertainty problem? And how do courts handle it under UCC 2-306?  “except that no quantity unreasonably disproportionate to any stated estimate or in the absence of a stated estimate to any normal or otherwise comparable prior output or requirements may be tendered or demanded”  Why is this a criterion of good faith? 33

34. Eastern Air Lines  How would you approach this as an economic question? 34

35. Eastern Air Lines  How would you approach this as an economic question? Who was in the best position to solve the informational problem? 35

36. Eastern Air Lines 36 Who might have predicted the Yom Kippur War?

37. Eastern Air Lines  Suppose you could purchase gas at $1 per gallon. How much would you want to buy? 37

38. Eastern Air Lines  Who was behaving opportunistically? Overinvestment: was Eastern using too much fuel? 38

39. Eastern Air Lines  Who was behaving opportunistically? Overinvestment: was Eastern using too much fuel? What is fuel freighting? 39

40. Eastern Air Lines  Who was behaving opportunistically? Overinvestment: was Eastern using too much fuel? What is fuel freighting? Gas is $4 a gallon. Your tank is half full. You spot a serve station sell gas at $3 a gallon an you tank up. Problems? 40

41. Eastern Air Lines  Who was behaving opportunistically? Undersupply: Was Gulf looking for an excuse to get out of the contract? 41

42. Eastern Air Lines  Who was behaving opportunistically? Cf. Orange and Rockland at p. 333 42

43. Eastern Air Lines  Who was behaving opportunistically? Cf. Orange and Rockland at p. 333  Buyer increases consumption when gas prices go up, propelling itself to be a large seller of power to other utilities 43

44. 44 George Mason School of Law Contracts I N.Requirements Contracts F.H. Buckley fbuckley@gmu.edu

45. 45 Contract Price > Market Price Market Price > Contract Price Supplier Supplier wants to sell as little as he can Buyer Buyer wants to buy as much as he can Requirements Contracts Price fluctuations and the Incentives of the Parties

46. Empire Gas 324  What was the contract? And why did American Bakeries enter into it? 46

47. What happened to oil prices in 1979? 47

48. Empire Gas  Which explains American Bakeries’ projected switch from gas to propane To buy propane solely from Empire For approximately 3,000 conversion units, more or less depending upon requirements of buyer 48

49. What happened to oil prices in 1981? 49

50. 50 Contract Price > Market Price Market Price > Contract Price SupplierGulf wants out Buyer Eastern wants to enforce contract Requirements Contracts Price fluctuations and the Incentives of the Parties

51. 51 Contract Price > Market Price Market Price > Contract Price Supplier Empire Gas Buyer American Bakeries But what if it’s the other way around?

52. 52 Contract Price > Market Price Market Price > Contract Price Supplier Empire Gas Wants to enforce Buyer American Bakeries Wants out But what if it’s the other way around?

53. 53 Contract Price > Market Price Market Price > Contract Price Supplier Empire Gas Over-supply Buyer American Bakeries Under- consumption Empire Gas The demand for propane declined as gas prices fell

54. Empire Gas  What was the contract? Does the buyer owe good faith duties not to underconsume? 54

55. Empire Gas  Posner: If there aren’t any good faith restrictions, that would make this an option contract, and requirements contracts are not option contracts 55

56. Empire Gas  Posner’s good faith duties: Buyer can cancel if a change in his business makes the contract too costly  Southwest Natural Gas at 329 56

57. Empire Gas  But here: No reason given by buyer No change in fleet of trucks No business emergency 57

58. 58 Contract Price > Market Price Market Price > Contract Price Supplier Wants to enforce: Empire Gas Buyer Buyer wants out: Empire Gas Requirements Contracts

59. 59 Contract Price > Market Price Market Price > Contract Price Supplier Supplier wants out: Eastern Airlines Buyer Wants to enforce: Eastern Airlines Requirements Contracts

60. 60 Contract Price > Market Price Market Price > Contract Price Supplier Wants to enforce: Empire Gas Supplier wants out: Eastern Airlines Buyer Buyer wants out: Empire Gas Wants to enforce: Eastern Airlines Requirements Contracts