UK: Case Law Update On Claiming Hedging Profit And Loss – Interplay Between Physical And Paper Contracts

Last Updated: 24 October 2012
Article by Nigel Kushner

The courts have recently shown willingness to consider hedging contracts as an integral part of the physical market. Where they are used as a means of hedging, difficult questions can arise about the relationship between the paper and the physical transaction if the physical transaction runs into difficulties. The usual intention is to match an exposure in the physical transaction by use of a suitable derivative, a future, option or swap intended to act as protection against market movement.

Where the physical transaction does run into difficulties and claims for damages are contemplated as result of an alleged breach, two questions commonly arise when considering the interrelation between the derivative position and the physical transaction; firstly, can expenses incurred in prospectively protecting the physical position be recovered; secondly are the damages to which the innocent party is entitled be increased or reduced as result of any hedging position that party has adopted? In each case, the threshold question is whether the paper transaction is left out of account.

Choil Trading SA v Sahara Energy Resource SA [2010]

Sahara contracted to buy a quantity of naphtha FOB from Choil. In breach Sahara rejected the goods. Choil resold the goods for a higher price. Choil made no physical loss. However under its hedging arrangements Choil made a loss.

The contract stipulated that:

"Neither party shall be liable for any consequential, indirect or special losses or special damages of any kind arising out of or in any way connected with the performance of or failure to perform the agreement"

Choil recovered its hedging losses. The Hon Mr Justice Christopher Clarke ruled:

"I do not regard the damages so far discussed as consequential, indirect or special....It did not require any special knowledge to realise that hedging was what Choil was likely to do. It was regarded as a normal and necessary part of the trade."

Glencore Energy v Transworld Oil [2010]

Glencore bought a quantity of crude oil FOB from Transworld. In breach, Transworld failed to make shipment. Glencore made a loss. Glencore closed out their hedging contracts. Glencore made a gain. Transworld argued that the close out of Glencore's hedging position was in mitigation of its losses, and damages payable by Transworld should be net of that gain.

Glencore argued that the hedging position was an independent transaction, not linked, and therefore not appropriate to set off. Damages were set off. Blair J ruled:

" ... Glencore not only did but was required to mitigate its loss by closing out its hedges....Hedging is on the evidence an integral part of the business by which Glencore entered into this contract for the purchase of oil, and since the closing out on early termination established a lower loss than would otherwise have been incurred, that has to be taken into account when determining recoverable loss.....To put it another way, if the seller had duly performed the contract Glencore would have closed out its hedges at the then current prices, and there is no reason to put it in a better position in the case of non-performance."

Addax v Arcadia Petroleum [2000] 1 Lloyd's Rep 496

In Addax v Arcadia Petroleum [2000] 1 Lloyd's Rep 496, the court (Mr Justice Morrison) took into account the contracts for differences that the claimants (sellers) had entered into, as part of their decision to elect for a 'deferred price option' for the Brent crude which was the subject of the sale contract. He also said, as regards the costs of the hedging instruments, that they were:

'an integral part of the calculation of the net position, and if the net position is a directly relevant loss, so must the hedging costs be so regarded. To extract the costs of the hedging devices is wrong in principle and has no commercial merit ... It was I think wholly foreseeable that if the claimants took a position which was otherwise than back-to-back with their contract with the defendants, they could cover their position with one of a multitude of hedging transactions available. While the contract instrument used may well vary from trade to trade (or possibly trader to trader), the defendants must have foreseen the need for the claimants to get cover.'


Potentially these cases open the door to the recovery/set off of hedging losses/gains in commodity disputes. However, the Court/Tribunal will need to satisfy itself that in the particular circumstances the parties knew or reasonably should have known that the position would be hedged. In short, the court has shown itself willing to consider hedging contracts as an integral part of the physical market. Traders must be aware of this and ensure that their paper positions are demonstrably closely connected with, or not, as the case may be, the physical transaction.

If you want hedging positions to be factored in:

  • Incorporate an express term dealing with hedging losses (for the avoidance of any doubt).
  • In the absence of express terms, make express pre-contract representations (in writing if possible) stating intention to hedge exposure on the physical contract.
  • Ensure internal accounting systems show a link between the physical and derivative.
  • Account for and clearly record the costs of the hedge (i.e. broker fees) – as these are generally recoverable if incurred pursuant to an act of mitigation following a breach.
  • Provided it is reasonable to do so, following a breach of the physical, any open hedging positions should be closed out in order to mitigate further losses.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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