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How Trafigura lost US$254 million on oil and gas hedges


ONE of the world's biggest traders, Trafigura, booked a US$254 million loss from oil and gas market hedges last year, highlighting the challenges traders face when taking large loans to protect against price swings in illiquid commodities.

To be sure, those losses are on paper and could be eliminated or turn into gains in the future if the market turns in Trafigura's favour. Or they could get bigger if the opposite happens.

The hedging losses at privately owned Trafigura, which made a net profit of US$873 million last year, have not been previously reported.

Like many other trading houses, Trafigura has moved into the fast-growing, global market for liquefied natural gas (LNG).

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Privately owned traders Vitol and Gunvor and listed Glencore are also expanding in LNG and said they were using hedges to protect their exposure in that sector.

In 2018, Trafigura signed a deal with US company Cheniere to buy LNG for 15 years and export it to Europe and Asia. On signing the deal, Trafigura hedged its exposure to US LNG prices against sharp price moves in the rest of the world.

But hedging LNG is complicated and contains risks, says Trafigura's own 2018 report and its auditor PwC, which reviewed and signed off on Trafigura's accounts for last year.

To hedge the deal, Trafigura had to rely on a combination of liquid prices such as those of US natural gas or Brent crude and assumptions on the correlation of those liquid benchmarks to illiquid global LNG prices for up to five years forward.

"This hedge is not perfect but it is the best one available out there at the moment," a Trafigura source said. As the LNG market develops, he said, more instruments will appear.

"It is extremely difficult to effectively hedge these long-term contracts, especially in a new market like LNG," said Arnaud Vagner, founder of Iceberg Research. Vitol also said contract maturities created hedging complexities.

International financial reporting standards (IFRS) require companies to mark-to-market - or measure the changes in fair value over time - the short and long positions they use for hedging.

In addition to LNG, Trafigura in 2018 hedged its US oil pipeline and refining deals against sharp moves in US crude versus Brent prices.

To hedge LNG, pipelines and refining Trafigura built a short position with a fair value loss of around US$1.9 billion using liquid instruments such as Brent, US natural gas and diesel.

The margin calls were financed via a revolving credit facility and other bank lines adding to Trafigura's debt, which stands at a total of US$32 billion. Its adjusted net debt - debt less cash and inventories - stands at US$6 billion.

On the other side of the hedge - the long side - Trafigura had fair value gains of US$1.75 billion from LNG, pipelines and refining deals. The LNG portion of the gains was US$646 million.

Fair value gains and losses were up more than 10-fold compared to 2017, before Trafigura entered into those LNG, pipeline and refining hedging deals.

Fair value gains and losses impact both balance sheet and profits as they are included in the cost of sales.

Because the short position was built on liquid instruments, the fair value losses belonged to the so-called Level 1 accounting hierarchy - the strictest category that makes few assumptions.

By contrast, fair value gains were based on Level 2 and, in the case of LNG, on Level 3, the most judgmental category in the fair valuation accounting hierarchy, which is mainly based on price modelling rather than market prices.

"Changes in these estimates may significantly impact the group's future results," said PwC, adding that it was still able to conclude that judgements were reasonable and free from bias.

As losses from the shorts exceeded gains from the longs, Trafigura had to book a US$254 million loss representing a reduction of 22 per cent of the potential net profit it would have otherwise achieved in 2018. REUTERS

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