In 2008, Augustin Carstens, Mexico’s finance minister, decided to hedge the country’s entire oil export production, agreeing on a locked-in price per barrel. This insurance strategy required Mexico to buy put options (derivatives contracts that give the holder the right, but not the obligation, to sell oil at a predetermined price and date) for an ultimate cost of US$1.5 billion. But the gamble paid off: when world oil prices plummeted, Mexico made an US$8 billion profit on its hedge, and Augustin Carstens came to be known as the “world’s most successful, but worst paid, oil manager.”1
Mexico is far from being the only player in the oil & gas field to rely heavily on derivatives. Most of the large hydrocarbons producers, traders, and end-users hedge part or all of their exposure to price fluctuations. Extreme market volatility over the last year or so increased this need. In October 2011, Qatar became the first OPEC member to publicly acknowledge implementing a hedging strategy.2
Hedging also increased on the users’ end: Southwest Airlines saved about US$1.3 billion from its hedging program in 2008, and the merged United and Continental airlines hedged about 40% of their planned 2011 fuel consumption.3
A little-discussed but central consequence of this increased reliance on derivatives is its potential impact on damages claims in oil & gas disputes, particularly in arbitration proceedings.
Derivatives’ Impact on Monetary Damages
Derivatives contracts can increase or reduce the ultimate financial outcome of an oil & gas operation by limiting (through hedging) or exacerbating (by speculating on) the impact of price variations for the underlying commodity.4 Energy derivatives constitute an extremely varied group, encompassing thousands of different contracts, serving a seeming infinity of purposes. Derivatives are either standardized and traded in regulated exchanges or customtailored to a specific situation and traded over the counter.5 The following (deliberately simplistic) examples illustrate how derivatives contracts can affect the monetary outcome of oil & gas disputes.
In the first case, a hydrocarbons producer enters into a long-term supply agreement with a refiner. The price set for the successive oil deliveries is roughly indexed on the spot price of West Texas Intermediate, which rose considerably since the contract entered into force. Dissatisfied with the producer’s performance, the refiner unilaterally decides mid-course to terminate the contract. The producer initiates arbitration proceedings, claiming for its lost profit on the remaining deliveries. That monetary claim proves substantial, the price increase having resulted in a large upside for the producer on each delivery. The producer, however, had decided to limit its risk at the time of entering into the supply agreement and hedged its entire contractual output, limiting its losses in case of price decrease, but also limiting its profits in case of price increase. As a result of this strategy, the producer’s actual lost profits are considerably smaller than its damages claim, which is based on the contractually agreed prices.
Can the refiner argue before an arbitral tribunal that the producer’s claims should be proportionally reduced to actual lost profits? In that case, can the producer claim for the costs of hedging its output?
Click here to see FIG 1: Producer’s “Contractual” and “Hedged” Lost Profits
The second situation is diametrically different: A crude oil trader stores vast quantities of oil in the terminal it owns in the territory of a sovereign State. Betting on an increase in oil price, the trader decides to augment its exposure (and therefore its expected profits) to a price upswing by purchasing exchange-traded crude oil futures. These contracts allow (actually require) the trader to buy determined oil volumes in six months at today’s price. In the event of a price increase, the trader will profit from the difference between today’s price and the higher market prices six months from now.6 As a condition to the purchase of these crude futures, the trader posts as a deposit (also called “collateral” or “initial margin”) the physical quantities of oil stored in the tank farm, representing 15% of the value of its future contracts. Exchange rules require for the posted margin to never represent less than 10% of the trader’s position value, under penalty of immediate proportional reduction of that position.7 Two months later, the State where the “physical” oil is stored decides to crack down on foreign speculators and implements an 80% tax on all quantities of crude oil stored on its territory, seizing 80% of the trader’s crude. Not only does the trader lose large quantities of “physical” oil, but it also loses 80% of its posted collateral. The exchange immediately reduces its position by approximately 70%. Four months later, the trader’s market insight proves correct — oil prices have increased significantly. But the trader realizes little more than 30% of its expected gains because it was forced to unwind the largest part of its position before the oil prices started climbing. Assuming the trader is appropriately protected under a bilateral investment treaty and that the new 80% tax effectively violates its rights as an investor, the trader commences arbitration proceedings against the sovereign State.
Could the trader claim not only for the value of the seized quantities of “physical” oil but also for the profit lost because it was forced to reduce its position on the futures market after the seizure of its collateral?
Click here to see FIG. 2: Trader’s “Physical” and “Derivatives” Lost Profits
These two situations, albeit simplistic, illustrate how derivatives can impact the damages claimed in oil & gas disputes. Practical situations are varied, as reflected by the large variety of existing derivatives products. However, parties to international arbitration proceedings very rarely take the impact of derivatives into account when assessing damages. Two main reasons explain why derivatives are so seldom used in that context. The first relates to the exigency of factoring derivatives into the damages equation. The second pertains to the difficulty of identifying and assessing the derivative’s precise impact on oil & gas disputes.
Foreseeability of Hedging and Speculative Strategies
Can the parties to an arbitration include derivatives in their damages assessment? In concrete terms, could they rely on derivatives in order to reduce or augment the amount of damages they claim? In the first of the two above examples, could the refiner argue for a reduction of the producer’s damages claim based on the fact (or mere intuition) that the producer had hedged its output? In the second situation, could the oil trader claim for increased damages based on the profits lost from its derivatives trades?
Of crucial importance in answering these questions is determining whether the impact of derivatives on the damages claims is foreseeable or not. The foreseeability of damages remains a cardinal tenet of the legal theories of damages, both under the civil law and common law systems. Damages become compensable when the parties could have foreseen them at the moment of the commission of the action causing that damage. Conversely, damages that were unforeseeable when that action was committed are unlikely to be compensable. In the present case, this translates into determining whether or not the party at fault could have foreseen that the use of derivatives would have an impact on the victim’s ultimate prejudice.
This central issue raises several related questions: Is the mere use of derivatives foreseeable in the context of the present dispute? Is the use of a particular type of derivatives more foreseeable than another (for instance, a “vanilla” exchange-traded crude oil futures instead of a customtailored swap aimed at covering a specific set of commercial risks)? Is the derivatives operation so risky or so highly leveraged that it will result in an unforeseeable outcome? Should hedges be treated differently from speculative operations? Many other issues come to mind when addressing real-life situations. Determining the foreseeable character of derivatives’ impacts ultimately remains a factual issue, subject
to the arbitral tribunal’s discretion. Derivatives are thus much more likely to be taken into account in a complex dispute opposing two large and sophisticated parties involved daily in the global oil & gas markets, than what would be the case in a dispute involving a small and unsophisticated respondent with limited market knowledge. Likewise, the tribunal could have to determine whether the nature, object, degree of sophistication, or even outcome of a derivatives operation could be reasonably foreseen. This factual approach is not exempt from drawbacks, particularly in that it provides for differentiated treatment based on the parties’ individual situations.
Difficulty of Assessing Derivatives’ Impact on Damages
If the parties to an arbitration can take into account the impact of reasonably foreseeable derivatives when discussing damages issues, they might still face considerable difficulties in doing so. The first difficulty would be to fix: indentify the derivatives at stake, which starts by forcing the parties to acknowledge they entered into a derivatives contract and to disclose the nature, importance, and specificities of these operations. Confidentiality, or at least discretion, constitutes a prerequisite for derivatives trading, particularly in the energy field. It therefore becomes extremely difficult to determine a party’s derivatives position precisely. The trading of these derivatives further complicates the picture — trading can result in significant changes in a party’s derivatives position over a short period of time. In the case of publicly traded futures or options, confidentiality becomes paramount to avoid unwanted market reactions. Likewise, investment banks or commodity traders often create over-the-counter swaps, forwards, and “exotic” derivatives contracts to suit the specific need of a particular client on the basis of confidential information and proprietary algorithms. Detailing the functionality and even disclosing the mere existence of these contracts could result in significant commercial or financial disadvantages for the party required to do so. For all these reasons, parties to an energy dispute are very unlikely to voluntary disclose how derivatives would affect their damages. Any effort to compel an opposing party to do so is therefore likely to require an important discovery process, often at a significant expense.
The second difficulty would be to assess precisely what these derivatives’ actual outcome would have been “but for” the subject event. It took more than two years for the most sophisticated financiers to unwind derivatives portfolios involving Lehman Brothers and AIG after those institutions collapsed in late 2008. Although often less complex than most of the now infamous credit-default swaps, commodities derivatives allow assessment of their interplay with a separate dispute only at considerable cost. In other terms, seeking to factor the impact of derivatives into a damages calculation (be it to augment or to discount the outcome) comes only at significant expense. Any ensuing “battle of experts” over these derivatives’ role further increases these costs.
That last consequence of involving derivatives in damages discussions may well constitute one of the best reasons for doing so: Derivatives likely represent an expensive and cumbersome tool to increase or decrease the damages at stake, which makes them a powerful weapon to force a settlement or limit the opposing party’s ability to claim for specific damages. A respondent could be well advised to raise an argument based on derivatives when answering a damages claim. The opposing party, now facing the potential for a costly, unilateral, and probably damaging discovery process, might well decide that limiting a particular quantum claim, or dropping it altogether, constitutes a preferable course.
Conversely, a claimant could invoke the impact of its own derivatives trades to claim disproportionately larger amounts than those at stake in the underlying dispute. The opposing party, facing massive damages claims and the unappealing prospect of a costly counter-expertise, could then be tempted to agree on quantum before the tribunal’s decision on the merits or simply initiate settlement discussions. In a nutshell, parties to an oil & gas dispute should not overlook the possibility of factoring derivatives into their damages claims — not only as a means to directly influence the tribunal’s decision but also as a strategic component in a sophisticated damages strategy.