Recovering hedging losses in commodities contracts
Producers, sellers and buyers of commodities all live with price risk, where prices fluctuate between the time of sale and the time of delivery. Price fluctuation can be particularly dramatic when there are unforeseen market or world events.
To guard against these risks, traders regularly hedge their positions. Where a counterparty defaults, how does the law treat hedging losses and which losses are legally recoverable? Firstly, let us try to simply define hedging.
What is hedging?
As we have said, the principle of hedging is to protect oneself against market price fluctuations. One might limit potential profits but also losses.
In a basic example, when a farmer plants a field of wheat in September, he expects to fetch a price of US$100 per ton upon harvesting the wheat the following July, but there is a risk that wheat prices may fall the next summer to US$80 per ton due to a glut in the market.
Recognising this risk, the farmer could turn to the futures market in September, where he might find a futures contract to sell his wheat for US$90 per ton for delivery the following July. If it costs him US$80 per ton to produce the wheat, he will make a profit of US$10 per ton. Let us assume the farmer hedges a third of his production by selling that volume by way of a futures contract for US$90. He is guaranteed a price of US$90 per ton for that third of production, regardless of whether the price goes up or down by July.
If the July price is indeed US$100 per ton, the farmer will have lost out on US$10 per ton on the futures contract but he will have made a profit of US$20 per ton on the cash price for the remainder of his production.
If the price goes down to US$75 per ton (below the cost of production), the farmer will have lost out on his cash price but will have made a profit of US$15 per ton on the futures contract.
If the July price is US$90 per ton, then the farmer will have made a profit on both the cash and futures sales.
By hedging part of his production, the farmer has protected against at least some of the loss. He may not make as much money as he would have if the price went up and he sold all of his crop at US$100 per ton, but he has not lost as much if the price goes down.
Very often, a trader will take an opposite futures position to her or his physical sale or purchase to hedge price risk. If you buy a physical, you sell a future and vice versa.
Traders of all commodities, including energy, place hedges via futures contracts and options, with the possibility to close out their positions early for a fee if the market is perceived to move against them.
How does English law treat hedging in sale contract disputes?
So, what happens when you have hedged a trade and your counterparty defaults on the physical contract giving rise to a classic claim for contract versus market price as at the date of default? If you make a loss on the hedge, is that loss recoverable as damages arising from your counterparty's default? If you make a profit on the hedge, do you need to bring that into account so as to lessen your claim for physical damages?
The answer, as is often the case in law, is maybe. Ultimately it will depend on the facts of the case and the evidence available to the tribunal or court. English law continues to develop in this area and there have been some important decisions in recent years that aid parties' understanding of recoverable loss.
The law on breach of contract and damages
The starting point for any claim for damages is to establish a breach of contract. If you can identify a breach of contract, next you have to demonstrate that the losses you have suffered were caused by the breach. After that, you must show that the losses in question were not too remote (i.e. either they flowed directly from the breach or were of a type which was in the contemplation of the parties at the time the contract was concluded).
In the case of hedging, the test of remoteness means that either the counterparty must have been aware that hedging was taking place and/or it would have been reasonable, in the usual course of the specific type of trade, for the parties to be hedging their physical contract positions.
Finally, English law requires the innocent party to mitigate their losses where reasonably possible and a failure to do so may limit the sums awarded for damages. In the context of hedging, mitigation would involve closing out a hedge where reasonable to avoid further losses.
English case law
Perhaps the starting point in English case law on computation of damages by reference to hedging is the decision in Addax Ltd -v- Arcadia Petroleum Ltd & Anor [2000] 1 Lloyd's Rep 493 where the Court accepted that between sophisticated traders hedging was an “integral part of the calculation of the net position and if the net position is a directly relevant loss, so must the hedging costs be so regarded.”
There are three more recent cases in particular which provide guidance on how the English courts will interpret hedging losses in the context of claims for damages.
Firstly, in Glencore Energy UK Ltd -v- Transworld Oil Ltd [2010] EWHC 141 (Comm), the Court decided that gains made from closing out external hedges were to be taken into account when assessing damages. The Court held that, where Glencore had closed out hedges as a result of Transworld's breach, the gains made as a result were to be taken into account, reducing Glencore's physical losses, when assessing contract vs market price, as a result. The Court used the principle of causation, ruling that the gains made were caused by Transworld's breach and therefore were to be taken into account in assessing the loss. Furthermore, the closing out of Glencore's position was a reasonable step in mitigation. Therefore, the English Court will not only take into account additional losses arising from hedging, but also profits from futures which offset losses made on physical trades.
Secondly, in Choil Trading SA -v- Sahara Energy Resources Ltd [2010] EWHC 374, the claimant Choil closed out its hedge following Sahara's breach resulting in paper losses. As with the Arcadia Petroleum case referred to above, the Court took into account the fact that Sahara would have been aware of the likelihood and the reasonableness of Choil hedging to protect itself against risk. Therefore, the losses incurred as a result of that hedge were recoverable.
Finally, a recent decision of the Court of Appeal, in Rhine Shipping DMCC -v- Vitol SA (The Dijilah) [2024] EWCA Civ 580, demonstrates that much will depend on the facts and circumstances of the hedge as to whether or not it will be taken into account when computing recoverable losses.
In that case, Vitol had an internal risk management system which matched the buy and sell positions of its various trading divisions so that it had full visibility of risks across its global portfolio of business. The particular hedge which Rhine sought to bring into account to reduce Vitol's losses was an internal transaction (virtually matching a trade) and not an external futures transaction with a third party. The Commercial Court decided that where there was no external hedge, Vitol's matching was not to be brought into account and, interestingly, that it was reasonable for Vitol not to have taken out external hedging at all to lessen its losses. This decision was appealed only on whether the internal matching should lessen Vitol's losses. The Court of Appeal dismissed the appeal.
Conclusions
The English courts recognise that hedging occurs where sophisticated traders are involved and, as such, that it is foreseeable that a trader will hedge. The extent to which hedges are brought into account to increase or lessen recoverable losses will depend on the facts of the individual case and be subject to principles of causation, remoteness and mitigation. In the right circumstances, hedging losses are recoverable under English law and any profits arising from futures should also be brought into account to reduce physical losses. Internal hedges, such as that in Rhine Shipping -v- Vitol, do not however generate recoverable losses.
Practical tips
- Evidence is key to the Court's assessment of whether hedging losses are recoverable. Ensure that you can properly evidence your loss and tie the hedging position to the physical contract.
- In any disclosure exercise, consider whether to press for more evidence of your counterparty's hedging position.
- It is important that you can show the Court or the arbitrators your hedging loss and clearly explain it where hedging positions can be extremely complicated.
- When a counterparty defaults, it is important to ensure that you consider your duty to mitigate and take appropriate steps to roll or close out hedges. Whilst mitigation steps need only be reasonable, if no steps are taken, this might bar the right to recover part or all of your hedging losses.
Originally published 19 June 2024
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.