Moneyball for Mitigating Losses with Derivatives
Moneyball for Mitigating Losses with Derivatives. Can Owners and Charterers Be Expected to Hedge Their Losses?
Paper presented at ICMA XX in Copenhagen 25th to 29th September 2017
Introduction
“If the highly paid, publicly scrutinized employees of a business, that had existed since 1860s, could be misunderstood by their market, who couldn’t be? If the market for baseball players was inefficient, what market couldn’t be? [i] This a quote from the introduction to THE UNDOING PROJECT by Michael Lewis where he refers to his previous book MONEYBALL – The Art Of Winning An Unfair Game. Michael Lewis tells the story of the Oakland ‘A’s baseball team using new-school data analysis to overcome one of the smallest payrolls compared to the other teams in the league reaching the playoffs for two straight years. They were arbitraging the mispricing of baseball players. Billy Beane, the coach with the approach, said in an interview with the Financial Times in 2011[ii] that he “was looking towards Wall Street as a guide”.
When I googled “moneyball” I discovered that this phenomenon had spread to “Moneyball for Government, Moneyball for Start Ups, Moneyball for Professors, Engineers, Bankers, Education and, believe it or not, Moneyball for Lawyers!
“At its heart Moneyball is about crunching numbers and relying on hard evidence–no emotion or tradition–to drive decisions”[iii]. Does this sound familiar to you?
If a fresh analytical approach had let to the discovery of new knowledge in baseball was there any sphere of human activity in which it might not do the same?”[iv] asks the author Michael Lewis in THE UNDOING Project where he explores new school data analysis further. This leads me to contemplate how much sphere there is in assessing damages.
In this paper, I would like to contemplate Moneyball applied to mitigating losses with the aid of number crunching data provided by derivatives instruments.
Could there be any inefficiency in the approach of how maritime and commodity losses are mitigated currently? Because applied data analytics can overcome market inefficiencies not only in professional sports but also in any field related to trading of any kind I would guess so.
Are derivatives fully understood?
I would question if derivatives are really understood by anyone. Do traders, charterers, ship owners and operators comprehend fully what freight derivative trading entails? Followed by the question are solicitors, barristers and experts fully in the know? From 20 years experience of dealing with derivatives and with people involved in the derivatives field as well as reading related decisions made in the UK and the USA I would hesitate to agree.
Let me share one ore two example with you. In the case of Transfield ER Futures Ltd. vs Deiulemar Shipping S.p.A. 2012 Eastern District of Louisiana Justice Duval concluded “As noted above, the very essence of these F[F sic!]As concerns commitments to perform shipping services in the future.”[v] Later that same year in the same district Justice Zainey in Farenco v. Farenco[vi] came to a different conclusion “FFA or Forward Freight Agreements are futures contracts based upon the cost of freight associated with maritime trade routes. FFA contracts involve financial speculation but they do not directly involve maritime commerce or an actual commitment to move cargo.”
In another case Flame vs. Industrial Carriers[vii] the expert involved claimed that freight derivatives could be traded by anyone including the judge himself. I had to disappoint Justice Dumar that Forward Freight Agreements can only be traded by institutions or by professional traders since they are highly regulated.
In the most recent case Vitol v Beta Renewable[viii] experts presented Vitol’s hedging activities and it was clear that Beta was aware of them however Carr J conceded that there was a fundamental problem with the hedging position. Reading the judgment, which is the first case conducted under the short trial scheme, it appears Vitol’s hedging activities were not presented in detail. Since there was no active market for biofuel swaps gas oil futures, the key market indicator, where traded instead. The bio fuel sale eventually failed due to lack of product. Vitol was obliged to roll over the hedging positions until it became clear the sale would not take place. Neither the rollover positions were recognized in the decision nor using gasoil as an alternative hedging product. This lead to damage calculations not to include Vitol’s hedging losses.
A note on the side: is a case involving derivative products and hedging operations suitable to be heard under the short trial scheme? Does this scheme allow the parties to present their case in detail and experts are given sufficient time to explain complicated matters like derivatives to reach a comprehensive conclusion?
It is a start like it was a beginning for Billy Beane and the Oakland ‘A’s. The data is there. Now we have to learn how to treat it.
Derivatives are not an insurance
When used as a hedge, derivatives are often referred to as protection or insurance for a specific underlying position. Google dictionary suggests that insurance is “ a thing providing protection against a possible eventuality.”[ix] One might say that this applies to swaps, i.e. derivatives, or future contracts too. However, if we look at it carefully the findings are quite different. There are several disparities. Insurance protects against eventualities and a one-off or annual premium is required. A swap trade, put on as a hedge, protects a specific commodity, cargo or freight exposure linked to a named vessel or identified sales transaction for a defined time frame. It is a tradable contract and can be rolled over[x] or extended depending on the circumstances of the linked underlying physical contract at issue. Insurance however is inflexible and limited. It is a singular event that does require payment of premium only. A derivative contract requires margin calls and constant monitoring. It is possible to insurance almost anything from Jennifer Lopez’s butt, Dolly Parton’s chest to Tom Jones’ chest hair,[xi] however it is not possible to trade derivatives on anything imaginable.
Not all commodities and vessel types have got existing tradable derivative products, and those have to be liquid enough to be able to trade in and out of a position at any time within trading hours. In such circumstances of lack of liquidity traders usually look to hedge by purchasing or selling swaps representing key market drivers, e.g. gas oil for bio fuel.[xii] They factor in and calculate the basis risk, but with the end effect what is traded and protected against, is the price fluctuation. If a key market indicator moves 3 points up or down the derivate would move in the same direction in equal measure.
In Glencore Energy and Transworld Oil[xiii] Blair J rather agreed with the respondents “that the position as regards to hedges is not res inter alios acta, nor is it equivalent to insurance”.
This case highlights the difference between derivatives as a hedge and insurance. Insurance is considered to be too remote as not foreseeable whereas derivatives are not too remote when hedging is an integral part of business and customary in that particular trade according to Blair J.
Factors to consider when hedging with derivatives are of course whether the party mitigating losses with derivatives will be compensated should the hedging positions turn negative. And should the hedging position turn positive, will the profit reduce the damages claim?
Foreseeability, Remoteness & Consequential Loss
As we know the test for recoverable losses is whether the losses are foreseeable by the claimant as well as the defendant. And further testing the remoteness of damages, i.e. whether damages are what was in the reasonable contemplation of the parties.[xiv]
The following examples of leading cases confirm that hedging losses are recoverable when hedging is an integral part of the business.
Morrison J found in Addax vs Arcadia Petroleum[xv] (late loading of a cargo of crude oil on FOB terms) “no sensible or commercial reason why the court should not take into account the costs of the hedging instruments…”. He continues: “The costs of the hedging devices are 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.”
This was confirmed by Christopher Clarke J, as he was then, in Choil Trading and Sahara Energy[xvi] when a naphta delivery was rejected due to not meeting contract specifications.
In his judgment, Christopher Clarke J noted that: “Trading companies such as Choil habitually hedge in order not to be caught with open positions in a volatile market. Choil was required to do so by its trade finance bank…..Sahara was well aware of the likelihood of Choil hedging, and the reasonableness of it doing so. It would have done the same.”
This does not only apply to oil and energy trading contracts but also to shipbuilding agreements. In Parbulk v Kristen Marine[xvii] four bulk carriers were contracted and a loan agreement was taken out. The MOAs were cancelled and the claimants claimed losses on costs resulting from the cancelled loan agreement plus the swap costs and banking fees. The defendant knew about the loan agreement and hedging thereof. Burton J found that “..the Claimant’s entry into the hedging arrangements was indeed reasonably foreseeable, and hence not too remote. Compliance with the hedging obligations also cannot, in my judgment, be characterised even arguably as unreasonable, and I am unpersuaded that it matters how such requirement came about…..”
In The MSC Amsterdam[xviii] however the court found that the hedging loss incurred by the consignee for his copper cargo were not recoverable as they were not foreseeable from the point of view of a shipowner. Traffigura’s copper cargo was stolen under fraudulent bills of lading. It had to roll over its hedging positions to mitigate however Trafigura was only awarded damages based on the value of the cargo (which had increased noticeably) and the consequential losses.
Quantum culminates to hedging losses plus lost profit
Let’s go back to Glencore Energy and Transworld Oil for a moment. Glencore bought Ukpokiti oil from Transworld in March 2008 for loading end March that same year. Simultaneously (within two days) they sold brent oil futures and they sold the physical cargo to BP. First the vessel MV “Narmada Spirit” got delayed due to tug problems turning from engine failure to the replacement tug being kidnapped. Glencore accepted the repudiation by Transworld on 22nd May and consequently closed out its hedging position immediately. This resulted in a loss of $8,099,960. Glencore pledged their damage claim on the broken contract to amount to $11,112,626 – the difference between the contact price agreed between Glencore and Transworld and the value of the cargo on the date when it should have been delivered (the delivery dates were moved back to 25 to 27 June 2008). Blair J decided that Glencore was entitled to damages resulting out of their hedging loss[xix] plus the loss of profit of the commodity sale in the sum of $8,665,496 instead of the difference between the contract price and the value of the cargo at the scheduled delivery dates. He reasoned “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.”[xx] The doctrine of “Loss of Expectation“ applied here is well established however this decision has set the scene for paying closer attention to all aspects of a trader’s integral part of business.
The conclusion is mitigated hedging losses are recoverable as long as they are presented as an integral part of the business.
Can Owners and Charterers be expected to hedge?
Freight derivatives are an integral part of freight trading nowadays. The nature of the chartering business has changed over the last two decades. Chartering departments of commodity trading houses become disponent owners taking in vessels on long-term charter to optimize their freight exposure. They need to justify their existence and have become profit centers too. Prior to the age of Forward Freight Agreements (FFAs) chartering departments of trading houses were merely responsible to source freight to assist their commodity traders. Since the millennium freight traders are required to trade physical freight as well as FFAs, risk optimization and risk reduction to be monitored. Unpredictable market conditions in current political and geographical climates challenge any trader to protect their exposure and forward physical positions. According to the Baltic Exchange the physical freight volume and swaps volume is of equal size in the dry bulk market. For tankers the FFA volume is still smaller than the seaborne trade volume. So one could say that hedging and the use of derivatives is an integral part of the chartering business nowadays. Though not everybody, in particular only a minority of shipowners, trades forward freight agreements.
Now imagine that a shipowner is a let down by his charterer redelivering the vessel prior to the agreed minimum time charter period. Under normal circumstances the shipowner will try to find alternative employment. What happens if there isn’t another charter available for his vessel? Until now the shipowner has claimed damages from the time the charter was broken until the agreed time charter period should have come to an end. In essence this means the unpaid hire. I would like to suggest in such a case, for example, the shipowner could enter the forward freight agreement market and sell FFAs for the remaining period. And he should close out this hedge the moment he finds a new employment for his vessel. The result of this hedging position, either the gain or the loss, should then be included in the calculation for damages.
Since Thai Airways International v KI Holdings[xxi] it has been established that a business should always weight its options before taking action to mitigate their loss. This is particularly the case where alternative means of mitigating may exist. And they should do so without further delay. This could include talking to experts and advisors. We have to bear in mind “There will also be occasions when a claimant will have failed to take reasonable and adequate steps to mitigate his loss, and as a result part (or all) of his loss may be disallowed.”[xxii] So shipowners better watch out.
Should a vessel breakdown and perhaps be delayed by several months charterers need to protect and mitigate of the losses they may experience due to this delay. If they have traded and put a hedge on this particular charter they are well off to keep the hedge in place. Now what happens to the cargo owner that could encounter a sale consequently not taking place? I would like to suggest that the cargo owner puts on the hedge the moment he is informed of the delay of the vessel. This of course is only possible if there is an existing derivatives of futures market for that product or alternatively for the key driver for that commodity. This could reduce the claim by the cargo owner towards the shipowner substantially.
Another situation I can think of is a new building delivery is delayed and the owner trades into FFAs to mitigate the not realised freight earnings until the time the vessel is actually delivered. The Charter of that a new building is always of course affected by that delay. In that case also the charter could enter the freight derivative market to protect his obligations towards his customers. And lending banks would, I am sure, welcome this approach.
Companies that engage in hedging and trading derivatives, i.e. that have experience and knowledge, can act without any delay to protect their vessel or cargo. I would like to suggest that those companies could be expected to hedge in order to mitigate their loss as hedging is an integral part of their business operation. If they don’t do so, should they be entitled to be allowed only part of the damages?
What is required and when should they not be expected to use derivatives to mitigate losses?
Before entering the world of hedging and trading derivatives a few parameters have to be met. First of all one has to acquire the knowledge of how to trade derivatives. A risk management policy has to be put in place. Then one has to setup clearing accounts with a bank or clearer of choice. Proper front and back office procedures have to be established internally and the traded positions have to be monitored constantly. To organize this it takes months in my experience. If shipowners, traders and charterers have not traded derivatives before, they cannot act without delay to mitigate in their losses with derivatives. Nor can they be expected to trade products they might not fully understand.
What to watch out for
I would like to highlight that hedging has to be done correctly and specific to the position, that is meant to be protected. If this is not the case hedging losses may not be acknowledged when assessing damages. In The “”Boni”[xxiii] “It was generally recognised that the hedging of petroleum products and other commodities was a desirable and essential method of minimizing price fluctuations and exposure to loss. The owners that operated tankers were presumed to have some understanding of the basic elements of the petroleum trade. However, on the evidence, the hedging transactions were not in accord with the sub- charterers’ own stated procedure, nor were they placed in accordance with accepted industry standards. Hedges were never an absolute protection against the risks of market fluctuations, but if placed properly they offered a large measure of price protection. They had not been so placed in the present case. Accordingly, the sub-charterers’ claim for equity loss would be denied.”
Let’s Play Moneyball
“Where a breach of contract has been committed, the innocent party will not in general be expected to go out and make hedging arrangements in case he suffers an exchange loss …..”[xxiv]
So far I have only come across cases where a hedge was traded into when the contract was formed. I have not found a single decision where the claimant sought the means of hedging the moment of the contract was repudiated. Why is that? Have I simply not found those decisions yet? I wonder has nobody used this approach, because the law has not developed in this field? Or is it simply because it is more convenient to rely one the established case law? Of course this gives certainty to the clients. However I wonder whether the old approach is always the most beneficial for the client. I actually believe (and know) that trading houses act the moment they know that their contract is in danger of not being performed. They might close out their hedge, as mentioned, or they put on protection had they not done so prior. When a charterer loses the hired vessel, his position is exposed and he may not be able to fulfill his obligations towards his customers. From a traders perspective it is a very responsible thing to engage in a hedging position. From a mitigation perspective this is equally responsible behavior. Why is this never mentioned?
I would like to spin this money ball a little bit further. I am still in search of the case where a hedging gain has been included in the pleadings and damages claim. I fully understand that claimants would prefer to keep those gains to themselves. Is this fair? Would the defendants not asked to see the trading book that shows the hedging activities? What stops them from doing so? Are they too afraid to that those hedging activities would show a loss, which could be adding to the damages? I am sure those losses would have been mentioned straightaway. Dare I encourage the parties to enquire of each other’s hedging positions? After all hedging is an integral part of the freight and commodity business nowadays. I would even go so far as to predict the future that hedging will not go away, but hedging activities will increase due to the highly volatile markets and uncertain political environment.
Leaning even further out of the window should damages be assessed assuming the parties have hedged? Though mitigating losses is not a duty but an obligation should experts apply hedging methods and use derivative prices and forward curves to calculate quantum irrespective of the parties involvement in freight derivatives and hedging activities? Should we apply this data available? To quote from MONEYBALL “If you challenge conventional wisdom, you will find ways to do things much better than they are currently done………People in both fields operate with beliefs and biases. To the extent you can eliminate both and replace them with data, you gain a clear advantage.” What would that look like you might ask. Let’s say a charterer has redelivered a vessel early going back to an example in a paragraph above. Traditionally the shipowner would calculate his loss by multiplying the daily charter hire by the days the vessel is redelivered early. The new approach could be taking the FFA value of that period and pretend a synthetic FFA sale and close out that position synthetically when the owner has found a new employment for the vessel. This synthetic loss or gain would then be added or subtracted to or from the physical loss.
Should a vessel be delayed and cargo owner fears for his commodity sale one could look at the commodity derivative prices and immediately hedge the delay synthetically. Should the sale fall through the cargo owner is theoretically protected from any price fluctuation. Especially in this case I believe cargo owners are obliged to protect their position. If they do not do this would they not fail their obligation to mitigate? It would only be fair to protect a ship owner to face damages not including hedging activities.
Needless to say, many aspects have to be considered before acting upon this provocative new approach always bearing in mind the fair treatment of the parties and their positions.
Let me close with words by Michael Lewis in Moneyball:
“No matter how successful you are, change is always good. There can never be a status quo.”[xxv]
[i] The Undoing Project by Michael Lewis, Introduction
[ii] FT: Let’s play Moneyball 11th November 2011
[iii] Moneyball for Government chapter one by Jim Nussle & Peter Orszag
[iv] The Undoing Project by Michael Lewis, page 16
[v] Justice Duval relied on the previous case of Brave Bulk Transport Ltd v Spot On Shipping Ltd – QBD (Com Ct) (Burton J) New York – 18 February 2009.
[vi] Farenco Shipping Co v. Farenco Shipping Pte, 2012 U.S. Dist. LEXIS 163469
[vii] Flame S.A. vs. Industrial Carriers, Inc. 2014 Eastern District of Virginia
[viii] Vitol S.A. v Beta Renewable Group S.A. [2017] EWHC 1734
[ix] Google Dictionary July 2017
[x] rolled-over: move one contract from one months to the next month of further out. This is done by closing the held position and opening, i.e. buying or selling a new swap or futures contract.
[xi] The 15 Most Bizarre Insurance Policies ever http://www.businessinsider.com/10-of-the-worlds-craziest-insurance-policies-2010-3?IR=T
[xii] Vitol S.A. and Beta Renewable Group S.A. [2017] EWHC 1734 (Comm)
[xiii] Glencore Energy UK Ltd. and Transworld Oil Ltd. [2010] EWHC 141(Comm)
[xiv] Hadley &Baxendale [1854] and The Folias [1979]
[xv] Addax Ltd. and Arcadia Petroleum Ltd. & Anor [2000] Lloyd’s Rep 496
[xvi] Choil Trading SA and Sahara Energy Resources Ltd. [2010] EWHC 374
[xvii] Parbulk AS v Kristen Marine SA and Aurele Trading Inc [2011] Lloyds Rep 220
[xviii] Trafigura Beheer BV v Mediterranean Shipping (“The MSC Amsterdam”) [2007] 1 CLC 594
[xix] I noticed that this case is sometimes reviewed and reported as Glencore encountering hedging gains that were accounted for reducing the overall damages. This was not the case.
[xx] Glencore Energy UK Ltd. and Transworld Oil Ltd. [2010] EWHC 141(Comm)
[xxi] Thai Airways International plc v KI Holdings Co Ltd [2015] EWHC 1250 (Comm)
[xxii] Foreign currency Claims, Judgements and Damages by Michael Howard, John Knott, John Kimbell Chapter 7 Page 179
[xxiii] Seaemblem Marine Ltd v Jahre Ship Services A/S and Jahre Ship Services A/S v Arochem International Inc (The “”Boni”) – New York Arbitration before R Glenn Bauer, Jack Berg and Larry Mahoney (Chairman) – 7 March 1994
[xxiv] Foreign currency Claims, Judgements and Damages by Michael Howard, John Knott, John Kimbell Chapter 6 Page 116
[xxv] Michael Lewis, Moneyball: The Art of Winning an Unfair Game