Hedging and Damages

June 2014

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In the event of late, non or mis-delivery of cargoes, shipowners may face claims from charterers or cargo interests. The usual measure of damage in these cases is:

  • late delivery: the difference between the market value of the cargo on the date it ought to have been delivered under the relevant contract, and the market value of the cargo on the date it is actually delivered. 

  • non or mis-delivery: the market value of the cargo at the time and place where it ought to have been delivered under the relevant contract, less any expenses the claimant has avoided through the non / mis-delivery.

In certain trades, however, it is common practice for traders of cargoes to use hedging to protect against volatile markets: crucially, the oil and metal trades. Where the traders are also charterers or cargo interests, hedging may have a bearing on the losses suffered and in turn, on the quantum of damages that they can recover against shipowners. It is therefore important to understand how hedging may be relevant and the key hurdles to be overcome to bring it into play.

It may be useful to recap on what hedging is. In simple terms, a trader of, say, copper, will buy a cargo based on a published reference price and will sell it on at some point in the future. To protect against the risk of a change in the price between the purchase and sale dates, he will hedge by selling an equivalent quantity of paper 'lots' at the same time as he buys the copper, at the same reference price. The same exercise will be repeated, in reverse, when the cargo is eventually sold.

Hedges are time limited. This means that when the trader sells lots at the outset, he has to estimate when he expects to be able to buy them back again i.e. the date he expects to be able to sell the copper cargo. The hedge must then be 'closed out' on that future date.

What if something happens to the vessel on the way to the discharge port which delays the cargo, such as an engine breakdown? This type of scenario can lead to claims by cargo interests or charterers against the shipowner. A delay may mean that closing time for the hedge comes around before the trader can sell the copper cargo. Once the hedge is closed, he is then left exposed to price fluctuations on the physical cargo - the price may change by the time it is eventually sold.

In this situation, a trader might do one of two things in respect of the hedge:

A.

    • He may take the chance of leaving the cargo unprotected. If by the time he sells it the price has fallen, shipowners may then face a claim under the usual measure of damage. 

    • In response to such a claim, shipowners might query why the trader allowed the cargo to become unprotected rather than to re-hedge; had he re-hedged, it might be (depending on the costs of re-hedging) that some of these losses would never have been suffered. So, hedging may be relevant in terms of mitigation.

B.

    • On the other hand, as the hedge expiry approaches, the trader may decide to extend it for another period depending on when he then estimates discharge will take place. This is known as 'rolling over'. 

    • Depending on how the market goes, the trader might ultimately make a substantial gain on the hedge, thereby reducing his overall losses.

    • The shipowner may then wish to bring hedging into play to set the gains off against the trader's claim.

Recent case-law suggests that hedging can be considered in such circumstances, but as the cases show, this is likely to turn on two issues: causation and remoteness.

The first case of significance was Addax Ltd v Arcadia Petroleum Ltd [2000] 1 Lloyd's Rep. 493, in which the claimant oil trader purchased a cargo of oil to sell on to the defendant. Delivery of the cargo was delayed and the claimant therefore hedged to cover risks. The claimant sought damages based on the difference between the profit it would have made had delivery happened as expected and the loss it suffered as a result of the hedges, totalling US$816k.

The court found that the usual measure of damages applied, i.e. the difference between the value of the cargo on the date it ought to have been delivered, and the value of the cargo on the date it was actually delivered.

The court commented that if it were wrong about the usual measure of damages applying and it ought to take account of what actually happened to assess the claimant's net position (which is what the defendant had contended), then it saw no reason why the cost of hedging instruments should not be taken into account.

Despite efforts from the defendant to categorise the hedging costs as too remote, the judge went on to say that in the oil trade it was wholly foreseeable that the claimant would have hedged.

In Trafigura Beheer BV v Mediterranean Shipping ("The MSC Amsterdam") [2007] 1 CLC 594, the claimant consignee of a cargo of copper cathodes brought a claim for mis-delivery against the shipowner carrier when the cargo was stolen under fraudulent bills of lading. The consignee had hedged its risks when it bought the cargo at the outset.

The consignee had to roll over its hedges as a result of the breach and it incurred a loss on those. It claimed for the value of the cargo plus the losses made on the hedges.

The consignee was awarded damages based on the value of the cargo, under TIGA 1977. Consequential losses are also recoverable under that Act, but here the court found that hedging losses were not recoverable as they were not foreseeable from the point of view of a shipowner.

Another notable decision, and perhaps the turning point in the case history, is Glencore Energy UK Ltd v Transworld Oil Ltd ("The Narmada Spirit") [2010] 1 CLC 284. This was a claim by a buyer of oil, against the seller, for non-delivery.

The claimant had hedged against market fluctuations and it made a gain on those hedges, reducing its overall losses from US$11m to $8.6m.

The claimant sought damages based on the full US$11m, being the difference between the contract price and the value on the date it ought to have been delivered. Had it recovered those, it would have gained a windfall of around US$2.4m against its actual losses. The claimant argued that this was appropriate because (a) hedging transactions were independent transactions which were res inter alios acta; and (b) hedges were analogous to an insurance policy and should therefore be ignored in the assessment of damages.

The court rejected both arguments and found that the claimant's action in closing out the hedges was taken in reasonable mitigation of its losses and should be taken into account in assessing damages. The claimant was awarded US$8.6m, not $11m.

This is an important decision because it establishes that there is no rule of law that hedges are always irrelevant to the assessment of damages.

In Choil Trading SA v Sahara Energy Resources Ltd [2010] EWHC 374 (Comm),
Sahara, an oil trader, sold a cargo of naphtha to Choil, another trader. Choil in turn agreed to sell the cargo to Petrogal.

The cargo was rejected by Petrogal by reason of its quality. Choil then hedged and tried to mitigate its losses by finding another buyer, Blue Ocean. Interestingly, Choil sold to Blue Ocean at a higher price than it would have sold to Petrogal.

Choil brought a claim for damages based on a specific SGA 1979 measure for breach of warranty of quality: it said that although the total Blue Ocean price was higher, it achieved a lower premium above the benchmark price from Blue Ocean than it would have got from Petrogal, because of the contaminated state of the product.

It also claimed for hedging losses; when it hedged to try to mitigate its losses after the Petrogal sale fell through, it ultimately suffered a US$2m loss on the hedges.

The court found that because Choil had achieved a higher sale price to Blue Ocean than it would have achieved in the sale to Petrogal, Choil had suffered no loss.

As to hedging losses, however, the court, citing Addax, found that Sahara would have been aware of the likelihood of Choil hedging as in this trade, hedging was an everyday occurrence. It was reasonable and expected for Choil to have hedged. As the hedge was taken out after the breach, it was attributable to a reasonable attempt in mitigation.

Finally, it is important to be aware of the decision in Transpetrol Maritime Services v SJB (Marine Energy) ("The Rowan") [2011] 2 Lloyd's Rep. 331. This was a tanker voyage charterparty dispute, and charterers were themselves oil traders. There were deficiencies with the vessel which resulted in its loss of oil major approvals. This in turn caused charterers to lose their onward sale of a cargo of vacuum gas oil onboard because their buyer had agreed to buy subject to those approvals being in place.

Charterers said if they had been able to sell the cargo as planned, they would have received around US$2m more than they ultimately got. Charterers had not hedged at any point. Owners said that charterers had failed to mitigate their losses by failing to hedge once they knew of the potential oil major approval difficulties.

As it happened, the type of hedging in this particular market was of a complex nature. The court found that it was too imprecise a tool and saw no reason why the charterers should have had to use it.

It appears that this decision was fact-specific; the type of hedging under discussion was clearly complex and highly speculative, which may well not be the case for more common cargoes.

The upshot of the above decisions is that courts appear to be increasingly willing to consider the affect of hedging on the assessment of damages, but the two key issues at play will be remoteness and causation.

In terms of remoteness, to date, hedging has only been found to be foreseeable as between traders in the same trade (Addax, Choil and The Narmada Spirit) and notably not as between shipowners and charterers/cargo interests. However, where hedging was found to be too remote, in The MSC Amsterdam, it must be remembered that this was in the context of a container vessel carrying numerous different cargoes. It is perhaps understandable that shipowners cannot be expected to know the trading tendencies of the owners of numerous different types of cargo. It is questionable, though, whether the same conclusion would apply if the vessel were, say, a tanker. A tanker owner may be familiar with how oil trading works, or at least the likelihood of hedging taking place. This is yet to be put to the test in the courts.

A further point to note is that remoteness works both ways. On the one hand the shipowner may want to say hedging losses should not be taken into account because they are too remote (as in The MSC Amsterdam) but on the other hand if the shipowner wants to reduce a consignee's claim by relying on hedging gains, he will presumably need to show hedging was foreseeable at the time the contract of carriage or charterparty was agreed.

As to causation, it is fairly clear that hedging can only be relevant to the assessment of damages insofar as the loss or gain in question is attributable to the breach by the shipowner. In practice though it can be difficult for traders to show that a particular hedge is connected with the late or undelivered cargo because traders will sometimes keep a book of hedges covering numerous cargoes at once. As a result it can be difficult for a cargo owner to match a specific sale/purchase transaction with a specific hedging instrument, and thus to show that a shipowners' breach caused any particular hedging loss or gain.

In conclusion, hedging is a relatively new issue in shipping disputes. How it will develop remains to be seen but considering the potentially dramatic effect it can have on the value of claims for late or non-delivery it is certainly one to watch.


We are grateful to David Morriss & Laura Wright of Holman Fenwick Willan LLP for this article.