Hedging For Commodities: Two Sides Of The Same Coin

Hedging has long been an intrinsic part of the energy and commodities sector. In its simplest form, hedging is a tool used to mitigate price risk by taking an equal and opposite position between the physical product hedged and the underlying market used as the hedging instrument. However, that is generally where the simplicity ends. Recently, both industry regulators and the courts have been required to grapple with complex issues around hedging, as well as with less common breach of contract cases.

Taking the regulatory issues first, as a result of requirements imposed by MiFID II and Regulation 149/2013 (the European Market Infrastructure Regulation or EMIR)1, firms are now putting in place hedging policies which determine when a trade is for the purpose of hedging price risk in physical products, and when it is for speculative purposes. These policies permit a range of hedging strategies (including anticipatory hedging, proxy hedging, macro hedging and portfolio hedging, as explained further below).

However, while such strategies might be acceptable to regulators, they cannot be viewed through a regulatory lens alone; consideration should be given to what happens if either you or your counterparty fails, or is unable, to perform the underlying physical contract. How a court (or arbitrators) view the commercial impact of your (or your counterparty's) hedging strategy, in the context of any damages claim following such a breach of contract, may be very different from the view taken by regulators.

This client alert highlights the need to consider hedging strategy with an eye to both compliance with regulatory rules, and the potential effect on damages arising from a breach of contract scenario.

Regulation

Hedging plays an important part in determining the extent to which MiFID II and EMIR apply to firms trading commodity derivatives, for the reasons summarised below:

MiFID II - ancillary activity exemption in article 2.1(j): commodity traders are required to exclude hedging transactions when calculating whether their derivatives trading activity is ancillary to their main business. MiFID II - position limits: position limits do not apply to positions held by non-financial entities, which are regarded as hedging transactions. EMIR - clearing threshold: commodity traders who are non-financial entities are required to exclude certain hedging transactions when determining if they exceed the clearing threshold. Hedging is defined in a similar, although not identical, way in EMIR and Regulatory Technical Standards 2017/592 (RTS 20) and 2017/591 (RTS 21), which accompany MiFID II2. The implementation of MiFID II and EMIR has brought...