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Recovering hedging losses

News / 02-10-2017 / London

Vitol SA v. Beta Renowable Group SA [2017] EWHC 1734 (Comm) 

In volatile commodities markets such as the oil and metals industries, prices of commodities tend to fluctuate significantly in a short span of time. It has, therefore, become common practice for commodity traders in these markets to minimise the risk of substantial losses in their physical sale and purchase transactions by entering into hedging arrangements.

Indeed, such hedging transactions have become an integral part of the business of commodity traders, with large commodity derivatives markets being established. This means that shipowners, who regularly enter into chartering arrangements with commodity traders, through the traders’ chartering arms, will find it increasingly difficult to deny their knowledge of the now-commonplace practice of traders in hedging risk. 

When a physical sale and purchase transaction fails, for instance, as a result of inability of the counterparty to supply the cargo, late delivery or cargo damage, traders would sometimes find themselves saddled with losses and liabilities under hedging arrangements that they are obliged to perform, notwithstanding the failure of the physical transaction. The trader in those circumstances would expect to be able to claim for such hedging losses suffered from the party in default. For the trader’s claim for hedging losses to succeed, a number of factors will be considered by an English court or tribunal.

This recent Commercial Court decision provides us with an opportunity to recap and update the principles and issues related to the recoverability of hedging losses. 

Principles of hedging – a summary

A trader hedges to manage physical risk.  A trader would typically purchase cargo based on current market prices. The cargo then takes some time to be shipped and delivered to the trader. At the point of delivery, market prices for the cargo may have fallen and the trader would potentially suffer a loss on the cargo if the cargo is sold then.

To minimise the risk of making significant losses, traders commonly enter into futures contracts for the same or similar type of cargo. A futures contract is a paper transaction that obliges a trader to “deliver” the cargo at a predetermined price on a specific date (the “expiration date”). As such, even if market prices fall at the point of delivery of the physical cargo, the trader can limit its losses (or indeed, profits) on the physical cargo by making a profit on the paper transaction on the expiration date.

If market prices have risen past the predetermined selling price of the cargo, the trader could “close out” the futures contract before the expiration date (thereby making a loss) and sell the physical cargo at current market prices. This is still likely to yield an overall net profit for the trader. Practically speaking, a trader would enter into a futures contract with an expiration date sometime after the trader intended to effect a physical sale of the cargo. This ensures that the risk of market price fluctuations at the point of sale no longer exists before the futures contract is closed out.

This practical consideration has legal implications in the event that the cargo becomes unavailable or is delayed due to the default of the seller or carrier of the cargo.

Recoverability of hedging losses

Vitol contracted to buy 4,500MT of “UCOME” biofuel from Beta, FOB Bilbao. They hedged the contracts against the risk of price fluctuations in the UCOME market by selling gasoil futures contracts.

The lifting period was contractually provided as 16 to 30 June 2016. Before the biofuel was to be delivered to Vitol, Beta informed Vitol that it was unable to provide the biofuel in accordance with its obligations under the contract. Beta admitted it to be a renunciatory or repudiatory breach. As a result, Vitol did not nominate a vessel as required by 27 June 2016, as provided in the contract.  Vitol sent a notice of contractual termination to Beta on 7 July 2016. 

The Commercial Court decision

The Court found Beta in breach of the sale and purchase contract. Vitol claimed for loss of profit of US$651,240 based on losses suffered as a result of its hedging activities; alternatively, US$351,830.25 in damages based on the ordinary market measure.

Vitol’s loss of profit claim was based on:

(i)  a (hypothetical) sub-sale of the biofuel for delivery in July 2016, had Beta delivered the cargo to Vitol under the contract. At the same time, in July 2016, it would have bought back the gasoil futures sold earlier in March 2016; and

(ii)  the hedge on gasoil futures. The evidence showed that Vitol’s gasoil futures had matured or, in other words, been sold in March 2016. 

Vitol claimed that it was common practice to hedge biofuel contracts against the risk of price fluctuations by selling gasoil futures contracts, since there was no biofuels futures market. Beta denied that there was a practice of hedging in the biofuels market and argued that Vitol’s hedging losses were too remote to be recovered.

The Court rejected Vitol’s claim for hedging losses, based on a “fundamental problem” being that Vitol's claim was not based on the necessary "like for like" basis. The gasoil futures contracts were sold in March 2016, many months before the biofuel would have been physically on-sold and gasoil futures bought back in July 2016 (as Vitol claimed). Since the gasoil futures contracts no longer existed in July 2016, because the physical transaction fell through, the price at which the gasoil futures were sold in March 2016 could not be compared against the average price for gasoil in July 2016.

In addition, the Court commented that the sub-sale was only a hypothetical one, as there was no evidence of such a sub-sale at the price claimed by Vitol.  In any event, Vitol and Beta did not have such a close and long-standing relationship from which it could be inferred that Beta had " detailed knowledge" of Vitol's business, such that Beta would have known of Vitol’s practice in making such sub-sales. 

Comment

The case reminds us that recoverability of hedging losses under English law is underpinned by the usual principles governing the assessment of damages for breach of contract. These are, in summary, as follows:

1.  Causation: there must be proof of a causal link between a breach and a hedging loss. A common practice of large trading houses is that they do not necessarily hedge each individual cargo, but hedge their overall trading book. This makes it difficult (although not impossible) to establish a clear connection between the physical cargo, sold under the sale and purchase contract, and the hedge.

2.  Remoteness: the hedging loss must either be one that flows naturally in the ordinary course of events from the breach, or which was within the contracting parties’ contemplation at the time the contract was entered into.   

If it is foreseeable that a trader would enter into hedging arrangements to minimise pricing risks for the cargo under a disputed contract, a claim for hedging losses is likely to be successful. In assessing whether hedging arrangements are too remote in a particular case, the following factors will be considered by a court or tribunal:

>  Industry practice – It is common in the oil, metals and perishables markets for hedging to occur;

>  Contractual framework – Whether hedging arrangements were communicated to the defaulting party before or at the time the contract was entered into; and

>  Sophistication of parties – A shipowner who owns a container vessel would not be expected to know the trading tendencies of the owners of different types of cargo packed in the containers. However, a shipowner operating an oil tanker cargo service would be reasonably expected to know that oil traders commonly enter into hedging arrangements.

Recoverability of hedging losses cuts both ways: on the one hand, a defendant may claim that hedging losses should not be taken into account because they are too remote; on the other hand, if the defendant wants to reduce a claim by relying on hedging gains, i.e., that the claimant should have properly mitigated its losses, the defendant will need to show that hedging was foreseeable at the time the contract was agreed. Even if foreseeability can be proved, a defendant faces potential evidential difficulties. This is particularly so in the case where a shipowner is looking to reduce a claim by a trader under a charterparty: the shipowner must prove that the trader in fact hedged in circumstances where the trader holds all the evidence and will not be inclined to show any connection between the physical cargo transaction and the hedge, particularly where the trader is in the practice of hedging its entire trading book and not just specific transactions. 

It is important to note that English law has yet to develop a consistent way of dealing with claims for hedging losses in the trade and shipping context. It is expected that, as the case law develops, assessment of damages in this area will undergo further refinement.

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