It was back in 2000 when Mr Justice Morison stated in Addax v Arcadia: “I can think of no sensible or commercial reason why the court should not take into account the cost of hedging instruments”. This bullish view (albeit obiter) appeared to mark a change in the court's treatment of hedging losses. Yet, twenty years on, traders and shipowners still have reason to doubt whether hedging losses can be recovered as damages.
This briefing considers six hypothetical scenarios based on leading cases involving hedging losses. We start by setting out our practical advice for parties pursuing or defending such claims, and conclude by considering the lessons that can be drawn from each hypothetical scenario.
Morison J’s comments in Addax v Arcadia1 gave rise to the proposition that gains or losses arising from a claimant’s paper position can be taken into account when determining their entitlement to damages. His central point was that if the costs of hedging devices are an integral part of calculating a party’s net position, they should be relevant to calculating a party’s recoverable loss. Why, then, does there continue to be uncertainty over the recoverability of such losses under English law?
As with any contractual claim, issues of causation, remoteness and mitigation come into play when assessing hedging losses. But there are also more specific hurdles to consider, such as:
- the complexity of the hedge used by or available to a trader;
- the availability of a replacement cargo at the time of breach; and
- the likelihood that the courts will calculate damages according to the usual market measure (i.e. the difference between the contract price and the market price at the relevant time).
The recent volatility in commodity prices and charter rates may well give the courts an opportunity to clarify the English law position in the near future. With that in mind, this article considers the challenges that parties continue to face in relation to hedging losses and the practical steps that can be taken when seeking to recover or account for hedging-related losses or gains.
Practical advice for traders and shipowners
Depending on whether you are a future claimant or defendant, the following steps can be taken to protect your position when it comes to hedging losses:
- Keep track of your hedges. This can be difficult where a global hedging book is used (see Scenario 1), but traders should seek to document and record hedges entered into for specific cargoes so any paper losses can be evidenced if the physical contract is breached. Similarly, if a shipowner is faced with a claim concerning a cargo that is hedged, they should give careful consideration as to whether there is a causal link between the loss and the hedge.
- Consider a post-breach hedge. If it is reasonable and straightforward to hedge a cargo following a contractual breach, consider doing so. If the hedge results in a loss, it will be still recoverable as a reasonable attempt to mitigate (see Scenario 4); and if the hedge is not put in place, you may be vulnerable to the accusation that you did not take reasonable steps to mitigate your loss (although failure-to-mitigate arguments are hard to establish – see Scenario 5).
- Make a pre-contract statement. To avoid the risk that a hedge will be deemed to be too remote, you may want to make a pre-contract statement declaring that a cargo will be hedged or is expected to be hedged (see Scenario 6).
- Incorporate an express term into your contract. If you are a trader, you may (depending on your strategy) want to include a clause in your contract stating that you have a right to be indemnified for any hedging losses. If you are a shipowner, you may want to include a clause in your charterparty stating that hedging losses are excluded.
This advice is explained in context below.
The current position on hedging losses under English law can best be understood by considering six scenarios. Each is based on a case involving paper losses or gains, but the facts have been simplified for ease of explanation.
Scenario 1: trader vs trader – non-delivery and an unparticularised hedge
Trader A enters into a contract with Trader B to purchase a cargo of biofuel for delivery in March. Trader A then hedges its position, with the intention of finding a buyer once the cargo is delivered.
Trader B has production issues and misses the contractual delivery period in March, but assures Trader A that it will deliver the cargo in June. The delivery period in the contract is amended and Trader A rolls over its hedge accordingly.
However, in June, Trader B declares that it will not be able to perform. Trader A accepts this repudiatory breach, terminates the contract and brings a claim for loss of profits on both its hypothetical on-sale and on its hedge (due to the imperfect nature of the hedge, the differential between Trader A's physical and paper positions widened between March and June, which would have resulted in a profit on both positions had the transaction been executed as planned).
This was the scenario in Vitol v Beta2 (in which Clyde & Co represented Vitol, i.e. Trader A). It might be expected that, in light of Beta's repudiatory breach, Vitol’s loss of profit on their hedge should be accounted for when determining their recoverable loss.
However, Vitol, like many traders, used a global hedging book to hedge its overall physical position. This can make it difficult to tie a particular hedge to a particular cargo and thus establish a causal link between the contractual breach and the loss on the hedge. For this reason, Carr J held that there was a fundamental problem with Vitol’s claim in respect of its hedge, in that the relevant futures (which were closed out in March) were “followed by two (unparticularised) roll-overs which may have made gains or losses”. As Vitol’s hedging claim was not based on the “necessary 'like for like' basis”, they were instead entitled to the usual measure of damages for non-delivery under s. 51(3) of the Sale of Goods Act 1971, being the difference between the contract price and the market price of the goods at the time when they ought to have been delivered.
Scenario 2: trader vs trader – late acceptance and an available market
On a falling market, Trader B enters into two contracts: one to purchase a quantity of oil from Trader A and one to sell the same quantity of oil to Trader C.
The price under the contract with Trader A is to be determined by reference to a quotation period commencing 14 days after the bill of lading date, whereas the price under the contract with Trader C is to be determined by reference to a quotation period commencing immediately after the bill of lading date (i.e. 14 days earlier). By pricing the contracts in this way, Trader B hopes to sell the oil to Trader C for a higher price than it costs to acquire it from Trader A. Trader B then hedges the risk of a rise in the market price of oil between the pricing dates in each contract.
The price of oil falls, as expected. However, Trader C (the on-buyer) fails to load the oil within the lifting window specified in the contract and instead takes delivery a week late. As a result, the bill of lading date is delayed by a week, meaning the dates on which the prices in both contracts crystallise are also delayed by a week. Consequently, Trader B makes less money than it should have on its physical position. It also seeks to correct its hedge by entering into futures contracts for the new pricing dates, but suffers losses on its hedge too.
This was the scenario in Addax v Arcadia. When bringing its claim for damages, Addax (Trader B) sought to recover its actual net loss from Arcadia (Trader C), being the difference between what it would have made if Arcadia had loaded the oil in accordance with the contract and what it actually made as a result of Arcadia's breach. In other words, Addax's claim was for its loss of profit on the physical sale plus its loss on the hedge, rather than for compensation according to the usual measure of damages for late delivery3 (which would, as it happens, have resulted in a better recovery).
In his judgment, Morison J held that Addax's approach was "right" and awarded Addax the damages that it had claimed. But he also held that had Addax calculated their loss according to the usual measure of damages, Addax would have been entitled to that higher figure, even if it meant that Addax would have recovered amount in excess of its actual net loss.
Morison J's reasoning was that the contract between Addax and Arcadia was "a commercial contract to be looked at on its own", so the market measure was the "true measure of damage". His view seems to be that as there was an available market for the goods at the relevant time (i.e. Addax could, in theory, have gone into the market and sold to an alternative buyer following Arcadia's breach), Addax was entitled to claim damages according to the usual market measure for late delivery, even though this would have exceeded the actual loss arising from its physical and paper positions. It should be noted, however, that the hearing was a summary judgment application, so Morison J was arguably less concerned with Addax’s purchasing and hedging arrangements than he may otherwise have been (as demonstrated by the next scenario).
Scenario 3: trader vs trader – non-delivery and no available market
Trader B enters into a contract with Trader A to purchase a cargo of oil for delivery in March. Trader B then enters into a contract to sell the oil to Trader C for delivery in April. As the prices in the two contracts crystallise on different dates, Trader B hedges its exposure to fluctuations in the market price of crude between March and April.
Trader A is unable to deliver in March. A new delivery period in June is agreed and Trader B rolls over its hedge for three months. However, in May, Trader A declares that it will not be able to deliver the cargo at all. Trader B has no option but to accept this repudiatory breach and terminate the contract. In doing so, Trader B establishes its loss of profit on the physical sale of the oil and its loss on the hedge, which is closed out in May.
But the loss that Trader B suffers on its hedge is a smaller loss than would otherwise have been incurred if the hedge had been closed out against the physical delivery of the cargo in June. The question that follows is: should the “loss saving” arising from the early closing out of Trader's B hedge be taken into account when calculating its entitlement to damages?
In The Narmada Spirit4, Blair J was of the view that it should. He contended that once Glencore (the claimant, represented by Clyde & Co) had accepted the repudiatory breach as bringing the contract to an end, it “not only did but was required to mitigate its loss by closing out its hedge”. Accordingly, the loss saving had “to be taken into account when determining recoverable loss”.
Blair J therefore awarded Glencore damages according to its actual net loss, rather than according to the usual measure of damages for non-delivery under s. 51(3) of SGA 1971. The reason for this is that there was no available market for the goods: it would not have been possible for Glencore to acquire a replacement cargo of that particular grade of crude oil following Transworld’s breach. So the measure of damages was to be assessed under s. 51(2) SGA 1971, which provides that where a seller wrongfully refuses to deliver the goods to the buyer, the “measure of damages is the estimated loss directly and naturally resulting, in the ordinary course of events, from the seller’s breach of contract”.
What is unusual about this decision is that mitigation was held to be necessary in relation to Glencore's futures contracts, even though these were distinct from the physical contract that was breached. Blair J looked at Glencore's physical and paper positions as a whole, rather than dealing with the futures contracts as separate transactions unrelated to the contract breaker.
Scenario 4: trader vs trader – defective cargo and attempted mitigation
Trader B decides to buy a cargo of naphtha from Trader A to sell to Trader C. The price under each contract crystallises on the same date. However, the naphtha supplied by Trader A turns out to be contaminated. Trader B does not have the right under its contract with Trader A to reject the off-spec cargo, but Trader C does. This means that Trader B loses its buyer and is exposed to risk of the market price falling while the naphtha is in its possession. Trader B therefore hedges its physical position and looks for a new buyer. Fortunately, the market goes up and Trader B manages to sell the naphtha to a new buyer for a higher price than that which it would have achieved under its contract with Trader C. Trader B therefore suffers no loss on its physical position. However, because the market has risen, Trader B has to close out its hedge at a higher price and therefore suffers losses on its paper position.
Can you recover your hedging losses in this situation? According to Choil v Sahara5, the answer is yes. Christopher Clarke J held that Choil’s decision to hedge after Sahara’s breach was a “normal and necessary part of the trade” and constituted “a reasonable attempt at mitigation”. Choil had taken reasonable and necessary steps to protect itself. Accordingly, Choil’s hedging losses were recoverable.
The key point to note here is that the claim, according to the Judge, was between two traders for whom hedging was “an everyday occurrence”. A straightforward option to hedge was available to Choil. Sahara did not require any special knowledge that hedging was what Choil was likely to do in order to mitigate its losses.
Scenario 5: trader vs shipowner – buyer withdraws and no hedge in place
Trader A agrees to sell a cargo of vacuum gas oil (VGO) to Trader B. Trader A charters a vessel to ship the VGO, but deficiencies with the vessel are revealed following an inspection and the vessel loses its oil major approvals. Trader A was selling to Trader B subject to these approvals, so it loses its buyer and has to sell the VGO to a new buyer at a reduced price. Trader A does not hedge its position at any point. When it brings a claim against the shipowner, the shipowner argues that, after losing its original buyer, Trader A should have hedged its price exposure in order to mitigate its loss.
Does the shipowner have grounds for such an argument? Perhaps. In Choil, the judge considered a hedge put in place after the breach to be a normal and necessary part of the trade. But in The Rowan6 (on which this scenario is based), the only hedge available for the cargo of VGO was an indirect hedge, known as a ‘crack spread’. Given that this type of hedge was complex and imprecise, Judge Mackie QC held that there was no reason why the claimant charterer/seller ought to have used it (despite being a trader). As he reminded the parties: “the obligation to mitigate is not a heavy one”.
Scenario 6: trader vs shipowner – cargo stolen and specialized hedge
Trader A arranges the shipment of containers of copper for onward sale. When the containers arrive at their destination, fraudulent bills of lading are used to steal the containers containing the copper. As Trader A hedged the copper, it also suffers losses when it closes out its paper position. It therefore brings a claim against the shipowner for the value of the stolen copper plus its hedging losses.
One might think, based on the other cases, that these hedging losses are relevant and recoverable. However, in The MSC Amsterdam7, Aikens J held that while hedging is common practice for metal traders, it does not follow that shipowners would be aware of this practice. He also concluded that shipowners do not generally concern themselves with what specific cargoes were in the containers and would not have knowledge of how metal traders hedge their cargoes. Accordingly, Aikens J held that the hedging losses claimed were not foreseeable at the time the shipowner entered into the contract and were too remote to be recoverable.
The distinction to make here is that the defendant carrier was the owner of a container vessel, rather than an oil tanker or bulk carrier. It would be far more difficult for an owner of an oil tanker to argue that it was not foreseeable that the oil on board their vessel would be hedged by whoever had title to it.
The following conclusions can be drawn from the above scenarios:
- There must be a causal link between the breach of the contract for the physical goods and the loss arising from a paper position. In Vitol v Beta (Scenario 1), a causal link between Beta’s non-delivery and Vitol’s rolled futures could not be established, so Vitol could not recover their loss of profit on the hedge.
- The availability of an alternative cargo/buyer may affect whether hedging losses or gains are to be taken into account. As there was an available market in Addax v Acardia (Scenario 2), damages could have been assessed according to the usual market measure for late delivery; whereas in The Narmada Spirit (Scenario 3), there was no available market, so damages were not assessed under s. 51(3) SGA 1979 and the “loss saving” on the hedge was taken into account.
- The complexity of a hedge used by or available to an innocent party may determine whether hedging should have been used in order to mitigate that party’s losses. In Choil v Sahara (Scenario 4), Choil’s hedge after Sahara’s breach was a “normal and necessary part of the trade”; whereas in The Rowan (Scenario 5), the only available hedge was deemed to have been too imprecise for it to have been used in mitigation following the shipowner’s breach.
- The hedge must be foreseeable. In The MSC Amsterdam (Scenario 6), hedging losses were not foreseeable to the owner of a container vessel - although it is doubtful whether the same decision would be made in respect to the owner of an oil tanker.
Ultimately, the question of whether a hedging loss or gain should be taken into account depends on precise facts of the dispute and each case must be analysed carefully. If you have any queries regarding hedging losses, please contact the authors.