UPDATE Catherine Jago FCIArb Expert Arbitrator and Consultant

Please find below a summary of the activities of CJH Energy and Catherine Jago this year. Attached are also her up to date CV and a copy of the paper she presented at the ICMA conference in Copenhagen in September this year on the Impact of Hedging on Damages. 

I would like to take this opportunity to wish all my contacts a healthy, happy and successful 2018, and I look forward to working with as many of you as possible in the near future.

Best regards 

Catherine Jago FCIArb

 CJH Energy Limited       

[email protected]  44(0)7748 936 977 www.cjhenergy.co.uk

                      

HIGHLIGHTS FROM 2017 and looking forward to 2018

v Catherine Jago has acted as an Expert Witness in over 11 disputes in 2017, giving evidence three times in the past year, in cases ranging from fraud in Pakistan, failure to perform, fraud in West Africa, failure to lift, quality deterioration, delayed delivery, breach of ship building contract, sound and unsound value of oil, and delayed delivery. In at least 7 of the cases hedging issues had to be taken into account. 

v  Catherine delivered a paper (attached) on the Impact of Hedging on Damages to the ICMA Conference in Copenhagen. She also presented on the same topic to several firms of solicitors, arbitrators, clients, institutes and P and I clubs, and is recognised as an expert on this subject. She is anticipating writing and presenting further papers on Hedging and the Law over 2018. 

v Catherine was one of the speakers on a panel discussing The Role of Experts in International Arbitration for the CIArb. 

v  Catherine Jago, a Fellow of the Chartered Institute of Arbitrators, is available for appointments as an Arbitrator in the field of breach of contract, commodity trading, shipping, pricing, and hedging. She has been awarded a Pupillage by the Worshipful Company of Arbitrators, and Clare Ambrose has agreed to be her pupil master.

v Catherine has been accepted as an CEDR Arbitrator and is a Supporting Member of the London Maritime Arbitrators Association, an Individual Member of the Singapore Chamber of Maritime Arbitration and a member of the Arbitrators Panel of the Swiss Chambers of Arbitration Institution in Geneva.

v Catherine Jago was one of the Arbitrators judging the Vis East Moot held in Hong Kong in March 2017. She took advantage of being in the Far East to visit several existing and prospective clients in Hong Kong and Singapore, including arbitral institutes there. 

 

 

v CJH Energy continues to undertake bespoke Consultancy projects on pricing, best practice and oil industry issues. In 2017 she was asked to advise on the interpretation of a pricing clause. 

 

v Catherine had an active year outside work taking part in the Vogalonga in Venice, rowing 32 km round the Venetian Lagoon and the canals of Venice in a gondoler, Venetian style. She also undertook wing walking in the Cotswolds, climbed a few mountains and flew a Jumbo jet (simulator!) from the new Hong Kong airport to the old Hong Kong airport. In 2018 she has plans to row Venetian style round the canals of Venice in full costume and mask during the Carnivale, to row the Vogalonga again and to go trekking in Japan. 

                               

 CJH Energy Limited

88a Kew Green Richmond TW9 3AP United Kingdom

 Catherine Jago FCIArb BVC Pg Dip Law BSc

             Tel: 44 (0) 7748 936 977  Email: [email protected]  Website: www.cjhenergy.co.uk

Catherine Jago has over 33 years experience in the commercial side of the oil and shipping industry. She is an Arbitrator, as well as Expert Witness, in the fields of oil and commodity pricing, trading, hedging and shipping. With her particular expertise in commodity risk management issues, including hedging, derivatives trading and issues around quantum, combined with her legal training, she can bring experience as an expert and add strength to an arbitral panel, or act as a single arbitrator, in oil and commodity trading and shipping disputes, and in more general commercial matters.

• Over 30 years experience in the commercial side of the oil industry involved with pricing, trading, shipping and hedging including as an oil trader, oil broker, oil pricing journalist and consultant. 
• Called to Bar 1997 by The Honourable Society of the Inner Temple
• Justice of the Peace since 1995 Chairman since 2002
• Fellow of Chartered Institute of Arbitrators
• Awarded Pupillage in 2017 by The Worshipful Company of Arbitrators
• Over 29 years experience as a respected expert witness on oil trading, pricing, hedging and shipping matters including piracy, fraud, breach of contract and other contractual disputes, insurance claims, contamination, ship building, refining, industry practice, hedging losses/gains, pricing clauses, oil valuation.
• Party appointed expert in oil pricing disputes.
• Lecturer on trading and risk management, including the impact of hedging on damages.
• Member of LMAA, LCIA, SCMA, GCCIG Arbitral Institutions and regularly attends events.
• Written books, and delivered papers and presentations on oil trading, pricing, credit control and hedging.
• Invited to take part as an Arbitrator in Vis East Moot Hong Kong 2017
• Delivered paper on the Impact of Hedging on Damages at ICMA Copenhagen 2017
• Member of Panel of Experts for CIArb YMG Event May 2017

ENDORSEMENTS

"The submissions of Counsel on this issue were informed by the expert evidence. The experts were admirably detached, fair minded and well informed. Ms Jago is a consultant with 30 years experience who, while much engaged in giving expert evidence, keeps up with the market and herself traded fuel oil through her company until 2010." – His Honour Judge Mackie QC in Galaxy Energy International Limited and Murco Petroleum Limited 2013

“In general I much prefer the evidence of Miss Jago on the issue of discount to that of Mr Roffey”  The Honourable Mr Justice Flaux in OMV Petrom SA and Glencore International AG 2015

"She was a witness of wide experience, high intelligence and appropriate detachment. She rightly declined to give views about matters outside her expertise and was cautious with her opinions about issues on the edge of it."

"In general I was more confident of the weight of the views of Ms Jago than those of X. X’s written report was impressively detailed. He was however very confident, perhaps too confident, of his expertise on a wide range of issues, particularly when it came to mitigation. He also seemed to identify with the cause of his client much more than Ms Jago."  – His Honour Judge Mackie QC in Transpetrol Maritime Services Limited and SJB (Marine Energy) BV “The Rowan”  2008

“I was impressed by the evidence of Mrs Jago, who was well qualified to give it, to the effect that the likelihood is that this cargo would be sold towards the end of the period ending 24th March at about $ 250/mt. At any rate I am not persuaded that SHV, acting reasonably, would have sold at a greater price. $ 250/mt. is the Platts price for 24th March but I accept Mrs. Jago's view that it is an appropriate price for the end of the period ending on that day rather than as the price for that day.”

Mr Christopher Clarke(as he was then) in SHV Gas Supply and Trading SAS and Naftomar Shipping and Trading Co 2005

EMPLOYMENT HISTORY

2003 onwards Ciren Energy Limited/CJH Energy Limited from 2010

Formally trading crude oil, oil products and bio fuels, primarily within the Far East, Europe and the Baltic States until 2010. Offering consultancy services for the oil and energy industry, including expert witness services and as an arbitrator. Lecturing on oil trading and hedging matters.

2001- 2003 Freelance Oil Consultant

Offering advice on performance improvement, organization and strategy to oil and energy companies, specialising in advice on trading and price risk management. Lecturing on energy price risk management, trading techniques, refining. Expert witness work. 

1997 – 2001 Arthur D Little

Management consultancy to international energy companies including Shell, BP, Ecopetrol, Fuchs, RWE, Sonangol, KPC, Reliance, Petrocanada and Sunoco. Projects involved performance improvement, strategy including market positioning and re organization to aid business development and growth within the energy sector. Expert witness work. Lecturing.

1989 – 1997 Freelance Oil Consultant

Offering advice on managing energy price risk, management consultancy to energy and other companies, lecturing on oil and energy trading, expert witness work, credit control, oil journalism. During this time also worked with Arthur D Little as an external consultant.

1987 – 1989 Poten and Partners

Broking gasoil, naphtha and gasoline and other products within Europe and USA.

1985 – 1987 ICIS-LOR

Oil journalist reporting on European and American oil products and crude oil markets.

1982 – 1985 BP Oil International

Price forecasting, planning, oil operations for BP worldwide.

1977-1979 Toxicol Laboratories

Running department to test new food, cosmetics and medicines on humans.

EDUCATION

1997

Bar Final Inns of Court School of Law, London Very Competent

1996

Postgraduate Diploma in Law, UWE Bristol Very Competent

1977

B Sc Honours Degree Biochemistry/Toxicology, University of Surrey Upper Second Class

 

MEMBERSHIP

Member of the Energy Institute

Fellow of CIArb.

Supporting Member of LMAA, LCIA and SCMA

On Arbitrator Panel of GCCIG

PUBLICATIONS

1. Two chapters on credit risk and oil pricing in Oil Traders Manual published by Woodhead Publishing 1995 - updated regularly
2. Co - author of “Trading Refined Oil Products” published 2014 
3. Author of chapter on the Impact of Hedging on Quantum in Oil and Shipping Litigation published in “Oil and Gas Trading” by Globe Business Publishing Ltd 2016

The Impact of Hedging on Damages

By: Catherine Jago FCIArb

CJH Energy Ltd, UK

Summary: For the purpose of simplicity, this paper focuses on hedging of oil. However, the principles can be applied to many other actively traded commodities including grain, freight, metals, interest rates, and exchange rates.

A number of legal decision have demonstrated that hedging losses, or gains, can be recoverable as damages for breach of contract in shipping and commodity cases. In some instances, causation and remoteness issues appear no longer to present a barrier, even between carriers and cargo owners. Hedging can also comprise an element of mitigation whereby a trader may close out a hedge early as a result of a breach, thereby saving possible hedging losses, or maintain or take out a new hedge on breach to protect against falling market prices. This paper will explore the types of cases when hedging gains or losses might apply to quantum determinations, the impact of hedging losses on claims for late or non delivery, how to encourage disclosure of hedging gains or losses, and explore the financial impact hedging can have on damages.

We will start by explaining when the consideration of hedging is appropriate to quantum, and continue by describing what hedging is, the types of tools available and what might influence the choice of hedge. We will discuss costs and basis risk (the difference between the way the hedge moves compared to the price of the underlying physical commodity) which means that hedges are rarely perfect. We will explore the ways hedges can become speculation, and how not hedging might be seen as speculation. We will look at managing price risk using other mechanisms such as back to back trading, and hedging a complete trading book rather than each individual trading risk. Some companies choose not to hedge and we will discuss what the impact might be of these decisions for litigation risk – should a defaulting party have to pay more because their counterparty chooses to accept trading risk and not hedge? Can hedging losses be excluded from a claim from damages and what are the risks?  

The approach adopted in this paper is from a practitioner’s experience rather than a lawyer.

Introduction

Hedging price risk in commodities is nothing new - the first known record of futures and forward contracts was described in Ancient Mesopotamia around 1750 BC when the 6th Babylonian King, Hammurabi, recorded a variety of rules in a code which was also the first to put forward the doctrine of innocent until proven guilty. More relevant to our story is that it allowed the sale of goods and assets to be delivered at a future date at an agreed price, thereby facilitating the first active derivatives market traded in temples. [1] The huge diorite stele on which the code was recorded was rediscovered in 1901 when a team of French archeologists unearthed it at the ancient city of Susa, Iran, after it was thought to have been plundered in a raid in the 12th century. Today the pillar is kept on display at the Louvre Museum in Paris.

The first modern futures contract commenced in 1851 at the Chicago Mercantile Exchange, which is the largest futures exchange in the world, for futures trading in grain. It took till 1981 for the first oil futures contract to be traded when the International Petroleum Exchange (IPE) launched a gasoil futures contract, with a Brent crude futures contract launched by the IPE in 1988. Futures contracts in gasoil, gasoline and West Texas Intermediate crude oil were similarly launched in the US at the New York Mercantile Exchange (NYMEX or “the Merc”).

One of the best examples of how to use hedging tools and manipulate the market (and one of my favorite films ever) is the 1983 film Trading Places, starring Dan Aykroyd and Eddie Murphy, where two individuals, one born with a silver spoon in his mouth, and one taken from the streets, manage to manipulate the orange juice market by releasing “fake news” and, by taking a position in orange juice futures prior to the release of the fake news, made a killing as the market moved in their favour.

At the time, futures were traded in a physical market using a system called open outcry. Trading of futures contracts took part in a pit where gaudily dressed traders (generally men) shouted and gesticulated at each other, thereby securing deals worth millions of dollars. In fact, the so called orange juice pit in the film was actually the WTI Crude oil pit – those eagle eyed of you can just see the word “OIL” in the top left corner in this photograph above. The debris of paper left on the floor are the deal slips – so much for compliance and recording of transactions in the 1980s! 

Dan and Eddie were speculating rather than hedging, although in their case, because they were in control of the fake news, they could be fairly certain how the market would react and that, as a result, they would make a fortune. It is important in the context of damages to understand the difference between hedging and speculation, which we will explore later.

Why should you be interested in hedging?

So what is the relevance of hedging to an audience of lawyers, arbitrators and non commodity traders? Considering the impact and relevance of hedging in commodity cases may seriously improve your bottom quantum line – failing to consider hedging may seriously damage your financial health and wealth.

Hedging, or at least considering hedging, is appropriate in any case in which quantum comprises a market price loss due to market movement.

For example, a ship owner fails to deliver the cargo on time – the price is dependent on the date of NOR (Notice of Readiness) which is delayed, during which time the market has fallen. The cargo owner claims that, as a result of the delay they have received a lower price then they would have done but for the breach, and are claiming for the loss.

Did they really suffer that loss if they hedged? Should they have hedged to mitigate their losses?

The courts have considered the recoverability of hedging losses generally, and in particularly with respect to foreseeability.

In Addax v Arcadia Petroleum [2000] I Lloyds Rep 493, the case involved a late lifting of a crude cargo, the losses for which were reduced because of hedging gains. The courts acknowledged that, between two traders in the crude oil markets, hedging losses were recoverable provided they were caused by the breach and satisfied the Hadley and Baxendale test for remoteness. In addition, Morison J found that it was unnecessary to foresee the exact hedge used.

However, in Trafigura Beheer BV v Medi Shipping Co SA (The MSC Amsterdam) [2007] 1 CLC 594, involving metals hedging and a breach resulting in non delivery of copper cathodes, in a case between a ship owner and metals trader the courts decided that a ship owner operating a container liner service would not have had hedging losses within its contemplation at the time of contracting sufficient to satisfy the Hadley and Baxendale test for remoteness. In this case it would appear Aikens J took the view that not only must the hedging loss itself be foreseeable, so must the precise hedging mechanism, a view contrary to that expressed in the Addax case and one which, in my experience, has not found favour since, particularly between two traders.

In contrast to the above case, the Court of Appeal agreed with the judge in Parbulk AS v Kristen Marine SA (2011) involving a financing sale and lease back arrangement for four special purpose vessels between Kirsten and Parbulk. The Court agreed that swap costs to manage interest rate fluctuations incurred by Parbulk, which were stipulated as a requirement by their bank, and the Claimant’s entry into hedging arrangements, were reasonably foreseeable. 

When it comes to ship owners resisting hedging claims, it now appears to me that the prevalence of the use of hedging instruments in ship financing, trading and chartering, through tools such as Forward Freight Agreements (FFAs), makes it increasingly difficult for them to argue that hedging claims are too remote and un-foreseeable. 

Another situation in which hedging should be a consideration is where a cargo becomes contaminated as a result of the ingress of water. The charterer’s buyer rejects the cargo. Charterer, and cargo owner, takes some time to find a replacement sale which is at a lower price partly because the cargo is now unsound (quality price risk), and partly because the market has fallen in the meantime (market price risk). The claim is based on a loss of market value as a result of the breach but did they hedge the market risk and therefore not suffer this loss in whole?

On the other hand, the underlying market may rise rather than fall. A cargo is rendered unsound but by the time a resale is found the unsound cargo is worth more than it would have been when the sound cargo was due to be sold and priced because the market has risen. Does the cargo owner have a valid claim? Yes, possibly if the cargo owner hedged their price risk and lost money on their hedge which was greater than the gain in the physical price.

In Choil Trading SA v Sahara Energy Resources Ltd [2010] EWHC 374 (Comm), Choil was entitled to recover hedging losses suffered as a result of their reasonable attempts to mitigate, despite the fact that the achieved a higher price for the physical naphtha as a result of the market rising after the breach and before they could achieve a replacement sale. These losses were categorised as “representing losses attributable to a reasonable attempt at mitigation.”

What is Hedging?

Hedging involves taking an equal and opposite position in the hedge to the underlying physical position.

To be as near a perfect hedge as possible it should be equal in quantity to the physical position. It should create an opposite position to your physical risk. So if you are long a physical cargo which is already priced (i.e. you have bought it at a price which has fixed) you should take out a short hedge, i.e. sell the hedge. And vice versa, if you are short physical you should go long a hedge, i.e. buy a hedge.

A hedge should always be linked to a physical position. If it is not taken out as a result of a physical position, it is not a hedge but speculation.

It should also be opened in proportion to the way the physical price risk is established, and closed in the same way as the physical price risk no longer exists. Let me explain what I mean by this.

Most oil pricing clauses allow for oil to be priced at a differential to the mean of a range of dates of a daily quoted price, say Platts Dated Brent quotation mean of the means (daily high and low) for 5 days after Bill of Lading.

Say a trader buys a cargo, comprising 1 million barrels, that would mean that on day 1 of the pricing dates 1/5th of the cargo, equivalent to 200,000 barrels, will change from a floating price to a fixed price. On day 2 the price for another 1/5th of the cargo will be fixed. So on day 2, 400,000 barrels will have been price fixed. For the proportion of the cargo for which the sale price has fixed, 400,000 barrels in this example, the trader is exposed to falling prices. The trader is not exposed to market movements yet for the 600,000 barrels of cargo for which the price has not been fixed. He therefore needs to open his hedge on the basis of 200,000 barrels per pricing day to ensure that he has an equal hedge to his physical price risk. Once the cargo has completely priced he should end up with a 1 million barrel hedge. He will then close out his hedge in proportion to the way his subsequent sale prices. So if, for example, it prices over the month of delivery (which for convenience sake we will assume contains 20 pricing days) the hedge will have to be closed on the basis of 1/20th of the total volume per pricing day, equivalent to 50,000 barrels per pricing day. If instead, the trader closed out all his hedge on the first pricing day, he would be exposed to falling prices for the rest of the pricing days since he would no longer have an open hedge position. His hedge would have become a speculation.

The trader in the above example needs a hedge such that if the worst happens, and the market falls, the hedge will make money to compensate him for his lower sale price when he comes to sell and price the sale. He therefore wants to sell a hedge. If the market falls, then he can buy back the hedge and take a profit which will compensate him for his lower sale price. However, if the market moves up the trader will make more money on his physical cargo, but he will have to buy back the hedge at a price higher than he had originally sold, thereby making a loss on the hedge. Effectively the trader has locked in the profit he sees when he takes out his hedge.

Taking a simple example, if he buys at 20 cents above Dated Brent price published by Platts 5 days after BL (Bill of Lading date), and sells at 40 cents above Dated Brent published 3 days after NOR (Notice of Readiness declared at the discharge port) and hedges using Dated Brent, he can lock in a profit of 20 cents per barrel by using, say, futures markets. In doing so the hedger protects himself from the market falling between BL and NOR. Futures markets have a number of benefits which other hedging tools may not have. Not least of which is the ability to minimise one aspect of basis risk – the volume. One Brent futures contract is 1,000 bbls, rather than forward markets which may be 500,000 bbls per lot.

The Impact of Basis Risk on a claim

Basis risk is the difference in the way the hedge moves compared to the physical position.

Ideally you want the hedge to move in exactly the same way as the physical position moves. So if the physical price goes up by US$1 per bbl the hedger wants their hedge to go up by US$1 per bbl. In order to achieve that it makes sense to hedge in a similar commodity to the physical commodity you have a price risk in. If you hedge the price of apples with a hedge based on the price of pears, if a rampant apple canker which pears are resistant to attacks all the apple trees in the world, your hedge in pears will not cover your losses in apples. Your basis risk between apples and pears is too great.

In the case of The Rowan [2011] 2 Lloyd’s Rep 331, HHJ Mackie QC accepted that the only hedging mechanisms available to hedge vacuum gasoil did not correlate well with the price of the vacuum gasoil and, given that the obligation to mitigate is not a heavy one, under these circumstances the charterer and cargo owner was not obliged to hedge in mitigation. However, where both parties normally hedge the physical risk concerned, it follows that parties will be expected to hedge their position after a breach.

Another aspect that can cause basis risks is the difficulty there often is in hedging the exact volume of the physical. Most hedges only allow you to hedge in given amounts. So if a trader is looking to hedge a cargo of 825,664 barrels he will often have to over or under hedge. Basis risk can result in a hedger loosing more money on the hedge than they make on the physical, or vice versa. 

To someone who is not familiar with basis risk, the idea that hedging a commodity may mean that there is a greater loss on the hedge than made on the physical suggests an incompetent hedger. Whilst this may be true, possibly they have used the wrong hedge or they have not hedged in the correct way, it is not an uncommon situation and can result in a claim for loss on hedging which has exceeded the gain on price of the physical. This can also occur where the hedge has to be held for longer than originally anticipated, perhaps due to a delay in delivery.

Hedges are taken out for specific months and they expire, generally, prior to the commencement of that month. The selection of the month for the hedge is based on criteria which include when the commodity is being priced and the market risk no longer exists, and when the hedge expires. It is no good taking out a hedge in March futures because the commodity price risk ends in March, if March futures expire in February. As we have seen earlier, it is vital to close the hedge when the price risk no longer exists. In this example April futures would be required. However, if the breach results in the pricing of the cargo being delayed, say till May, the April hedge will no longer be trading. In order to mitigate market losses, the trader would have to close out the April hedges and open them in June contracts. This process is know as “rolling the hedge” and depending on whether the market is in contango or backwardation [2], and whether the hedge is a short or a long hedge, this can result in extra losses greater than any profit made from the market moving in the trader’s favour.  

In a recent decision in the matter of Vitol SA v Beta Renowable SA (2017), heard under the Shorter Trials Scheme, the judge, Mrs. Justice Carr, agreed with Beta that Vitol’s hedging claim failed to compare like with like in that Vitol failed to particularise how they accomplished the hedge roll overs which formed the second leg to their claim.

The courts are also aware of the need to investigate the appropriateness of any hedge which forms part of a claim, either as the claim itself or in mitigation. In the New York case of The Boni, LMLN 6 August (1994), whilst it was recognised that owners operating tankers were presumed to have some understanding of the basic elements of the petroleum trade, which would include hedging as a means to minimise price fluctuations and exposure to risk, the mechanism of the hedging was not in accordance with the sub-charterers own stated procedures, or in line with accepted industry standards, hence the claim failed. Whilst this is an old case, it appears to demonstrate that claims against a carrier or ship owner are not necessarily unforeseeable.

With any hedging claim it is therefore important to demonstrate that the hedge is reasonable, and in line with company policy and normal industry practice, and has been correctly calculated. 

When is a hedge not a hedge and how can it become speculation?

It is crucial to understand the difference between hedging and speculation. Hedging reduces risk, speculation increases it. It is speculation that has got hedging a bad name. Who can forget the spectacular losses of US$1.4 billion Nick Leeson managed to build up through his fraudulent, unauthorised and speculative trading which brought down Barings Bank, the UKs oldest Merchant bank founded in 1762. 

If our hedger of the crude oil mentioned above chooses not to close his hedge in accordance with the pricing basis of the sale, i.e., closing it evenly over the pricing dates specified as 3 days after NOR, but thinks that he can do better by holding the hedge, maybe because the market is moving in his favour, the hedge is no longer a hedge but a speculative position. He is no longer mitigating his loss. The hedge is no longer a direct consequence of a physical position, but the trader has gone on a frolic of his own and taken a speculative position, un-related to the physical position since he is now no longer exposed to market price movement on his physical commodity. Why should a respondent pay for the claimant’s speculation?

This was the basis of the decision in the Singapore case of Prestige Marine Services v Marubeni International Petroleum (2011) whereby the court agreed with the arbitrator’s findings that, where the party is speculating on the price of goods through paper transactions and the profits or losses from which were not causally linked to the breach, the speculating party had to alone bear the risks.

Equally, perhaps the same argument could be made when a claimant fails to mitigate by hedging their market risk. Should a respondent have to pay for the claimant’s now speculative position, which may have come about as a result of the breach but has not been mitigated by the claimant through hedging.  

We have heard news earlier in this session of the impact of the New Flamenco decision in the Supreme Court which stresses that any quantum loss (or gain) must be as a direct consequence of the breach. In my humble opinion, the likely impact of the Supreme Courts decision on the inclusion in quantum of hedging losses or gains is to reinforce the requirement to ensure that hedging losses or gains are as a result of the breach. They must come about due to actions by the claimant to manage price risk on the commodity which forms the subject of the breached contract. But I await the conclusions of cleverer minds than mine who might argue differently.

Why do companies hedge? And why do some not hedge? And why do some say they do not hedge but actually do!

Hedging price risk is necessary for a trader if they do not want to be held to ransom by the vagaries of the market. When oil prices were stable, back in the 1970s, buyers were happy to pay fixed prices for term contracts, and sellers were happy to sell at fixed prices. But when prices started to rise, and then fall, and then rise and fall, the volatility drove traders to seek ways of protecting themselves from adverse price movements. Hence the development initially of a forward paper market when I was a baby trader in the 1980’s, and then the introduction of a regulated futures market conducted through an exchange, followed by more complex hedging tools such as swaps and contracts for differences.

Now few traders will be allowed by their shareholders and/or banks to hold large exposed outright positions. They will seek to protect their risk by either hedging or managing their price risk by means of back to back transactions.

However, it is true that not all companies hedge. Some may claim they have political and religious reasons for not hedging, although I am aware that many Middle East companies have trading arms able to facilitate hedging strategies on behalf of their parent companies. Others may believe that they are too small, or the volumes they trade are too small, to warrant setting up facilities to hedge their price risk, or they cannot afford to hedge.

Costs of hedging

There are costs involved in hedging. Trading accounts need to be set up, in advance of hedging, with futures exchanges, brokers and other potential counterparties to allow traders access to as many different hedging tools and counterparties as possible. In this way a trader hopefully gets the best prices and also the greatest access to the hedges they select, which is essential in order to open and close a hedge in accordance with the price risk being established and then ceasing.

It is no good trying to go into the market to hedge 200,000 bbls of hedge if the total hedge volume available over the whole day is 200,000 bbls. As a buyer you will end up pushing the price up against yourself. There is a need for plenty of different players in a market, and a reasonable volume of each contract traded each trading day to provide good liquidity. This requirement means that there are relatively few hedging contracts available for each commodity. This fact has influenced the pricing basis of commodity contracts which are now often price linked to a reference price of a benchmark commodity, For example, 95% of international crude oils are traded at a price differential to Dated Brent, a North Sea Crude oil[3]. Pricing against Dated Brent allows a trader to hedge the price risk using one or more of the hedging tools which have been developed around Brent.

A major cost in terms of cash flow, is the requirement to meet margin calls for hedges which are regulated to ensure financial performance is guaranteed by means of clearing mechanisms.  In order to open a hedge, initial margins have to be paid and these have to be maintained until the hedge is closed. In addition, at the end of each trading day the open position is compared against the settlement price for that position. Where the hedge is making a paper profit, money will be transferred into the hedgers trading account, but if the hedge is loosing money the clearing banks require the hedger to put up a variation margin calculated as the difference between the price at which the position was opened and the settlement price of the day. If the trader is unable to meet their margin calls than their position will be closed out.

Those who have watched Trading Places may recall that this was the downfall of the owners of the trading house looking to speculate on orange juice futures, causing their company to collapse.

Margin calls can be a hurdle for small companies who want to hedge their price risk. They may be making money on their physical, but cannot realize it until the price is fixed and payment made. But if they are making money on their physical they likely will be loosing money on the hedge, and potentially having to put up large margin calls, without being able to realize the profit on their physical cargo. In times of extreme commodity price volatility, this can force traders to change their hedging strategy, such a reducing their hedge from 100% to say 50%. In doing so they are increasing their risk exposure to volatile market prices. Or some traders may switch to hedges which are not cleared and are traded Over The Counter (OTC) between two parties without the involvement of a regulating body. This potentially increases the performance and payment risk.

Hedging a Trading Book as a whole

If a company says they do not hedge, as well as asking why they do not hedge, in my experience it is always worth looking at their website and financial statements – they can be very revealing! Other companies may say that they are internally hedged – Exxon has always been held out as an example of this as they claim they are fully vertically integrated. However, a company may say that they have not hedged a particular transaction, whereas what they actually might mean is that they have considered their market price risk on the whole of their trading book and only hedged their outstanding positions from that book.

For example, a claim may be for losses on a delayed delivery of 30,000 mt gasoil cargo in Asia due to contamination. The company was short gasoil in Asia, but possibly long gasoil in Europe. So overall in terms of volume they were balanced in gasoil, and their risk, which they might have been prepared to accept, was the location risk between how the Asian market moved against the European market. In fact, they have hedged – but hedged with another position. In this case, I would argue that it would be appropriate to create a hypothetical hedge strategy to demonstrate that had the gasoil in Asia been hedged alone, the profit or loss would have been X which should be accounted for in any claim. Had the breach not occurred, then the gasoil in Europe would have had to be hedged alone.

Hedging can damage your profit but reduce your risk exposure

Hedging is aimed at reducing risk, not increasing it. It is not gambling – in fact it is the opposite of gambling [4]. But what it does do, as well as minimising your losses, is restrict your profits. In hindsight it maybe that the profit would have been greater if there had been no hedge. But that is ignoring the purpose of a hedge which is to protect against adverse price movement, for which one has to relinquish the profits of beneficial price movements. As Warren Buffett said, “In the business world, the rearview mirror is always clearer than the windscreen”.  The success of a hedge strategy cannot be measured by hindsight trading. We could all make money if we could go Back to the Future!

There is a hedge where you can have your cake and eat it – options. In options you buy (or sell) the right to buy or sell a commodity. If you buy the option, you do not have to exercise it. So if the market moves in your favour you can allow the option to expire worthless, and only exercise it if the market moves against you. But options require a payment to the option seller of a premium which can be extremely costly. This option premium has to be paid whether or not you exercise the option. In general options tend to be used for strategic hedging – long term protection of, say, the revenue from an oil field to support funding. Operational hedges, for hedging shorter term price risk, generally tend not to make use of options.

Other ways to manage price risk

In some cases, Claimants decide to take out the market price movement in their claim, and in doing so avoid the issues of hedging the market movement. This simplifies the claim, and also avoids requests for potentially huge volumes of disclosure of the company’s normal hedging strategy, which many companies consider to be highly sensitive.

For example, a claimant may say that they originally sold the sound gasoil cargo at Platts gasoil 5 days after NOR on 20th March at plus US$10 per mt. The Platts benchmark price averaged over the 5 pricing days was US$500 so the invoice price would have been US$510 per mt.

However, as a result of a beach where by the cargo became contaminated, the sale of the unsound oil was made at US$5 below Platts gasoil 5 days after the new NOR on 22nd April by which stage the average Platts gasoil price was $490 so the price of the unsound oil was US$485 per mt. Instead of claiming the difference between the sound sale price of US$510 and the unsound price of US$485, giving a claim of US$25 of which US$10 is due to market movement and US$15 due to the unsound nature of the gasoil, they simply claim the difference between the two formula prices. i.e. the difference between the Platts premium or discount, in this example equivalent to US$15 per mt. Many traders will acknowledge that this is a fairer way to measure their loss as it is closer to the loss suffered as a result of the unsound oil, and closer to the loss they would have actually felt if market movement is removed from quantum. But in doing so they are acknowledging that the claimant hedged and any losses or gains should be taken into account by removing any loss caused solely by market movements. What this method of calculating quantum does not do is take account of actual hedging losses and gains which may be greater or less than market movement.

Can hedge losses be excluded through a contractual exemption clause?

Excluding hedging losses or gains from a claim can end up being a double edged sword. They limit claimant’s opportunity to claim hedging losses where they have made money on the physical commodity as a result of the breach, but also as a result of the breach lost money on the hedge. Nevertheless, some contracts now contain exclusion clauses which, so long as they are very carefully worded to include all likely breaches, can be held applicable.

In Choil, mentioned above, Christopher Clarke J held that a clause which excluded seller’s liability for “consequential, indirect or special losses or special damages of any kind” did not exclude hedging losses which were part and parcel of the claimant’s attempts to deal with the difficulties encountered when they were unexpectedly left with a cargo. This was where for both parties hedging was an every day occurrence and a normal and necessary part of the trade.

Conclusion

Hedging is far from a new phenomenon, but it has struggled on occasions to feature as an important element for consideration when looking at quantum in commodity cases. This maybe because of a lack of understanding of what hedging is about. Perhaps it is due to an unwarranted feeling that hedging is “betting” and the courts should not condone losses (or gains) from betting.

Since the principle of quantum is to, as best as possible, put the claimant in the position they would have been had the breach not occurred, if they would not have hedged and made money, or lost money, had the breach not occurred then it should form part of the quantum claim. The difficulty comes in deciding whether a claimant is reckless if they have not hedged a market risk, which exists as a result of a breach, under circumstances where they normally hedge.

In the over 28 years I have been an expert in this field I have never seen a case in court or arbitration which awarded losses on the basis that the claimant negligently failed to hedge their market risk.

I have been involved in many cases which have settled on the basis that the claimant says that they did not hedge, but on further investigation it appears that they chose not to because they were speculating that the market would work in their favour. Other cases settled because the party did not want to spend time investigating what hedging had been done and disclosing their daily mark to market documentation and accompanying vast reams of contracts and associated paperwork.

Nevertheless, in my humble opinion, whenever a claim involves a loss due to market movement, the issue of hedging should be raised and incomplete answers and explanations challenged.

For more information on the potential impact of hedging on damages please contact the author. 

Catherine Jago has over 35 years of experience in the commercial side of the oil and shipping industry. She is an Arbitrator, as well as Expert Witness, specialising in the fields of oil and commodity pricing, trading, hedging and shipping. With her particular expertise in commodity risk management issues, including hedging, derivatives trading and issues around quantum, she can bring practical experience as an expert and add strength to an Arbitral panel, or act as a single arbitrator, in oil and commodity trading and shipping disputes. She is the author of Trading Refined Oil Products” published in 2014, and has contributed chapters to the “Oil Traders Manual” and “Oil and Gas Trading” on Oil Pricing, Credit and the Impact of Hedging on Damages. She is a Fellow of the Chartered Institute of Arbitrators, and a supporting member of LMAA, SCMA and GCCIG (Geneva), and has recently been awarded a pupillage with the Worshipful Company of Arbitrators.

Catherine Jago FCIArb

[email protected]

(44) 7748 936 977

CEO of CJH Energy Ltd www.cjhenergy.co.uk

[1] A History of Derivatives: Ancient Mesopotamia to Trading Places, by Edmund Parker and Geoffrey Parker YouTube 17 December 2014

[2] Contango is where future prices are higher than prompt prices, and backwardation is where futures prices are lower than prompt prices

[3] Actually a mixture of North Sea Crudes oils referred to as BFOE – Brent, Forties, Oseberg and Ekofisk

[4] Gambling is defined as taking a risky action in the hope of a desired result. 

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