Does hedging play an integral part in mitigating the loss of falling oil prices?

04 May 2016

In our latest blog, Iain Sharp, partner at Rodyk & Davidson LLP, discusses Glencore Energy UK Ltd v Transworld Ltd case and the duty to mitigate loss.

Mitigation following a breach of contract – how far does the duty extend?

The rout in commodity prices continues to impact nations and stocks across the globe.  Already this year the price of oil has dipped below US$30 a barrel, with a seemingly unrelenting oversupply of crude and markets preparing for the return of Iran post-sanctions.  Sadly, falling prices often result in contract re-negotiations or default, leading to claims and innocent parties with goods on their hands and a difficult search for a willing buyer prepared to pay a reasonable price.

Following a breach of contract, the innocent party has a duty to mitigate the loss it has suffered.   However, failure to mitigate loss may prevent that party from recovering damages for avoidable loss.  A standard defence which the defaulting party often invokes to reduce the damages payable is that the innocent party has failed to act reasonably to mitigate its loss.  The burden of proving a failure to mitigate falls, however, on the defaulting party.

As one might imagine, the courts are generally sympathetic to efforts made by an innocent party seeking to deal with a breach of contract. The requirement to take 'reasonable steps' to mitigate loss is not a particularly high standard.  This so-called ‘duty’ requires reasonable steps to be taken to limit the losses that are incurred (and also to avoid incurring unnecessary expenditure in seeking to remedy the breach).  An innocent party need not, however, take unusual steps that would be outside the normal course of its business, or even incur undue costs. Reasonable costs of mitigation incurred by the innocent party will generally be recoverable from the defaulting party.

For example, in contracts for the sale of goods, the claimant seller will usually have to give credit for the market value of the goods at the time of termination. This requires the defendant buyer to establish two things:

•    that there is a market for the goods; and
•    the market value of the goods.

The courts are likely to penalise a claimant in damages where it has demonstrably and unreasonably failed to take any steps to mitigate its loss, or where the steps that it has taken are plainly inadequate. For example, where a claimant could potentially mitigate its loss by selling goods in the market, the courts will usually expect to see evidence of meaningful attempts to do so.

In a falling market, ‘reasonable’ offers may be hard to come by.  How long should the innocent party wait to sell the goods in the hope that market conditions might improve?  Should the innocent party continue to store goods (and incur charges) whilst it waits for a better offer? 

Although it might seem unpalatable, it could be reasonable for the innocent party to accept a lower offer to purchase goods from the defaulter.  In such circumstances, the innocent party would be wise not to waive its right to claim the losses suffered as a result of the defaulter’s conduct.

In the context of oil trading, recent English authorities have shown that hedging can be seen as an integral part of mitigation.  

In Glencore Energy UK Ltd v Transworld Ltd [2010] EWHC 141 (Comm), the buyer Glencore claimed against the seller Transworld for repudiatory breach of an FOB contract for Ukpokiti crude oil.  The parties agreed that there was no available market for Ukpokiti crude within the remit of section 51(3) of the Sale of Goods Act 1979.  

Glencore claimed for the difference between the contract price and the value of the Ukpokiti crude on the date it should have been delivered.  Transworld argued that Glencore had closed out its position early and therefore mitigated its losses.  Glencore was required to close out its position in order to reduce exposure to the accrual of greater hedging losses against which there was no physical cargo to offset.  To ignore the hedging position would effectively give Glencore a windfall.  

The court held that account was to be taken of Glencore’s reduced hedging loss.  Having accepted Transworld’s breach as bringing the contract to an end, Glencore “not only did but was required to mitigate its loss by closing out its hedges. To have allowed them to run on would have been to speculate in the movement of the price of oil, which Glencore has asserted is no part of its business for present purposes.”  

By closing out its hedges, Glencore established its loss.  On its own evidence, hedging was an integral part of the business by which Glencore entered into the contract.  Closing out positions is something that a claimant may be required to do, as part of its duty to mitigate its loss once its counterparty’s breach is clear.

Iain Sharp
Dentons Rodyk & Davidson LLP

Click here for full details of Oil and Gas Tading: A Practical Guide.