Home | DME - AUD Academy | Online Learning : Intro to Hedging

Principles of Hedging

Introduction
Futures contracts have been used to manage cash market price risk for centuries. Hedging allows a market participant to lock in prices and margins in advance and reduces the potential for unanticipated loss.

Hedging reduces exposure to price risk by shifting that risk to those with opposite risk profiles or to investors who are willing to accept the risk in exchange for profit opportunity. Hedging with futures eliminates the risk of fluctuating prices, but also means limiting the opportunity for future profits should prices move favorably.

A hedge involves establishing a position in the futures market that is equal and opposite to a position at risk in the physical market. For instance, if a crude oil futures contract represents 1,000 barrels, then a crude oil producer who holds (is "long") 1,000 barrels of crude can hedge by selling (going "short") one crude oil futures contract. The principle behind establishing equal and opposite positions in the cash and futures or options markets is that a loss in one market should be offset by a gain in the other market.

Hedges work because cash prices and futures prices tend to move in tandem, converging as each delivery month contract reaches expiration. Even though the difference between the cash and futures prices may widen or narrow as cash and futures prices fluctuate independently, the risk of an adverse change in this relationship (known as “basis risk”) is generally much less than the risk of going unhedged and the larger a group of participants in the market, the greater the likelihood that the futures price will reflect widely held industry consensus on the value of the commodity.

Because futures are traded on exchanges that are anonymous public auctions with prices displayed for all to see, the markets perform the important function of price discovery. The prices displayed on the trading floor of the Exchange and disseminated to information vendors and news services worldwide reflect the marketplace's collective valuation of how much buyers are willing to pay and how much sellers are willing to accept.

The purpose of a hedge is to avoid the risk of adverse market moves resulting in major losses. Because the cash and futures markets do not have a perfect relationship, there is no such thing as a perfect hedge so there will almost always be some profit or loss. However, an imperfect hedge can be a much better alternative than no hedge at all in a potentially volatile market.
Short Hedges

Introduction

One of the most common commercial applications of futures is the short hedge, or seller's hedge, which is used for the protection of inventory value. Once title to a shipment of a commodity is taken anywhere along the supply chain, from wellhead, barge, or refinery to consumer, its value is subject to price risk until it is sold or used. Because the value of commodity in storage or transit is known, a short hedge can be used to essentially lock in the inventory value.

A general decline in prices generates profits in the futures market, which are offset by decline in the value of the physical inventory. The opposite applies when prices rise.

Example 1 - Crude Oil Producer's Short Hedge

A crude oil producer agrees to sell 30,000 barrels a month for each of six months at the posted prices prevailing at delivery. When he agrees to the deal, posted prices are $70.50 barrel, but as market conditions appear to be weakening, he wants to protect his revenues against a decline, and executes a short hedge. The example shows how the producer's revenue is protected from the full brunt of a declining market.

In this example, the oil producer establishes hedges for the second, third, fourth, fifth, sixth, and seventh contract months against his production during the first, second, third, fourth, fifth, and sixth months ahead. Near-month futures positions are liquidated after a price posting is established (normally on the first day of the calendar month).

In a surplus crude market, spot prices generally fall faster than postings, regardless of whether prices decline more slowly, as in Case 1, or more rapidly, as in Case 2.

Date	Cash Market	Futures Market	Futures Results $/bbl.	Net Price Received $/bbl
Dec. 1	Commits to sell 30,000 barrels in each month for January, February, March, April, May, June crude at the posted price	Sells 30 crude contracts in each month for February, $70.00; March, $69.75; April, $69.50; May, $69.50; June, $69.25; July, $69.00
Case 1: Slowly Declining Prices
Jan. 1	Posted price for January crude: $71.00/bbl.	Buys back February contracts at $70.50	($0.50)	$70.50
Feb. 1	Posted price for February crude: $70.50/bbl.	Buys back March contracts at $69.75	0	$70.50
Mar. 1	Posted price for March crude: $70.00/bbl.	Buys back April contracts at $69.00	$0.50	$70.50
Apr. 1	Posted price for April crude: $69.50/bbl.	Buys back May contracts at $68.50	$1.00	$70.50
May 1	Posted price for May crude: $69.50/bbl.	Buys back June contracts at $68.75	$0.50	$70.00
Jun. 1	Posted price for June crude: $70.00/bbl.	Buys back July contracts at $69.50	($0.50)	$69.50
Case 2: Rapidly Declining Prices
Jan. 1	Posted price for January crude:$70.00/bbl.	Buys back February contracts at $69.50	$0.50	$70.50
Feb. 1	Posted price for February crude: $69.50	Buys back March contracts at $68.75	$1.00	$70.50
Mar. 1	Posted price for March crude: $69.00	Buys back April contracts at $68.00	$1.50	$70.50
Apr. 1	Posted price for April crude: $68.50	Buys back May contracts at $67.50	$2.00	$70.50
May 1	Posted price for May crude: $68.50	Buys back June contracts at $67.75	$1.50	$70.00
Jun. 1	Posted price for June crude:$69.00/bbl.	Buys back July contracts at $68.50	$0.50	$69.50

Selling Prices ($/bbl.)

		Unhedged
Month	Hedged	Case 1	Case 2
January	$70.50	$71.00	$70.00
February	$70.50	$70.50	$69.50
March	$70.50	$70.00	$69.00
April	$70.50	$69.50	$68.50
May	$70.00	$69.50	$68.50
June	$69.50	$70.00	$69.00
Average	$70.25	$70.08	$69.08
Increased cash flow
Case 1	$70.25 - $70.08 = $0.17 x 180,000 barrels = $30,600
Case 2	$70.25 - $69.08 = $1.17 x 180,000 barrels = $210,600

If the producer could not lock in revenue, he could be faced with shutting in all or part of the production.

The example shows two possible outcomes. Case 1, with relatively high posted and futures prices, and Case 2, with relatively low posted and futures prices. Short hedges for February, March, April, May, June, and July (against January, February, March, April, May, and June production) are initially established on December 1.

Assuming the futures hedge is placed on December 1, the near-month contract is January and the second month out is February. Because the January crude futures contract expires three business days prior to December 24, and the posted prices for January are not finally established until January 2, the example attempts to have the liquidation of the futures coincide with the setting of the posted price.

In summary, the nearby contract is used to hedge current production. For example, the February futures contract is utilized to hedge January production because the timing is better matched.

Example 2 - Petroleum Marketer's Long Hedge, Rising and Falling Markets

On September 7, the spot price for the heating oil contract on the futures exchange is $2.0242 and the cash market price at the fuel dealer's location is $2.0142 a gallon. There is therefore a 1 cent differential, or basis, between the exchange price and the retailer's location.

The dealer agrees to deliver 168,000 gallons to a commercial customer in December at $2.1742 per gallon. On September 7, he buys four December heating oil contracts (42,000 gallons each) at $2.0442, the price quoted that day on the exchange. Total cost: $343,425.60 (42,000 x 4 x $2.0442).

Case 1 - Rising Prices

On November 25, the fuel dealer buys 168,000 gallons in the cash market at the prevailing price of $2.0642 a gallon, a 1 cent differential to the exchange contract’s cash quotation of $2.0742, Cost: $346,785.6.

He sells his four December futures contracts (initially purchased for $2.0442) at $2.0742 a gallon, the current price on the Exchange, realizing $348,465.60 on the sale, for a futures market profit of $5,040 (3 cents a gallon).

His cash margin is 11 cents (the difference between his agreed-upon sales price of 70 cents and his cash market acquisition cost of 59 cents for a total of $18,480 ($0.11 per gallon x 168,000 gallons)

	Cash Market	Futures Market
Sept 7		Buys 4 December futures contracts for $2.0442 per gallon
Nov. 25	Buys 168,000 gallons at $2.0642 per gallon	Sells 4 December heating oil futures for $2.0742 per gallon
A cash margin of:	$18,480 or 11¢/gallon plus
A futures profit of:	$5,040 or 3¢/gallon equals
A total margin of:	$23,520 or 14¢/gallon

Case 2 - Falling Prices

On November 25, the dealer buys 168,000 gallons at his local truck loading rack for $1.9642 a gallon, the prevailing price on that day, based on the exchange contract's cash quotation of $1.9742 cents a gallon.

He sells his four December futures contracts for $1.9742 cents a gallon, the futures price that day, realizing $331,665.6 on the sale, and experiencing a futures loss of $11,760 (7 cents a gallon).

	Cash Market	Futures Market
Sept 7		Buy 4 December heating oil futures
		at $2.0442 per gallon
Nov. 25	Buys 168,000 gallons	Sells 4 December heating oil futures for $1.9742 per gallon
A cash margin of:	$35,280 (21¢/gallon) minus
A futures loss of:	($11,760) (7¢/gallon) equals
A total margin of:	$23,520 or 14¢/gallon

In summary, the fuel retailer guarantees himself a margin of 14 cents a gallon regardless of price moves upwards or down in the market.

With the differential between cash and futures stable, as in Cases 1 and 2, spot-price changes in either direction are the same for both the exchange and the marketer's location. As a result, a decline in the futures price, which causes a loss in the futures market, is offset cent-for-cent by the increase in the cash margin.

Example 3 -- Protecting future acquisition costs

On February 1, a gas utility decides that the prices reflected in the futures market for the second quarter are less expensive than the current cash market prices. The utility does not want to wait until the second quarter to buy gas because it fears that the price at which it buys gas may move significantly higher than its sales prices. The utility buys natural gas futures contracts for April, May, and June.

To fix its acquisition costs, the utility might take a long hedge against its forward sales. If wholesale buying prices, or production costs, increase, profits on the futures market will offset the rising costs in the cash market, keeping the retail margin constant.

Similarly, if wholesale costs decrease, the lower acquisition costs will be offset by a loss on the futures.

Case 1 - Rising Prices

On February 1, the gas utility buys 10 natural gas futures contracts in each of three months, April, May, and June for $6.50, $6.75 and $7.00 per mmBtus, respectively. The cost of the futures purchases are $650,000 for the April contract, $675,000 for May, and $700,000 for June, for a total cost of $2,025,000.

On March 27, the utility buys 100,000 mmBtu of natural gas in the cash market for the then prevailing price of $7.00 per mmBtu, and pays $700,000. That is $50,000 more than it budgeted when it anticipated a price of $6.50 per mmBtu. The utility also sells back its 10 April natural gas futures contracts at the then-current price of $7.00 so it doesn't have to take delivery through the exchange. The contracts originally purchased for $6.50 ($650,000), are now worth $7.00 ($700,000) yielding a gain in the futures market of $50,000.

Cash market purchase of:	$700,000 plus
A futures gain of:	$50,000 equals
A net amount of	$650,000 or $6.50 per mmBtu, the budgeted sum for April.

As cash prices continue to be strong during the second quarter, his hedge looks like this:

	Cash Market	Futures Market
1-Feb		Buys 10 natural gas futures contracts in each of April, May, June for $6.50, $6.75, $7.00, respectively
27-Mar	Buys 100,000 mmBtu at $7.00	Sells back 10 April contracts, $7.00
26-Apr	Buys 100,000 mmBtu at $7.25	Sells back 10 May contracts, $7.25
26-May	Buys 100,000 mmBtu at $7.75	Sells back 10 June at $7.75

Financial Result	April	May	June	Quarter
Expected Cost	$650,000	$675,000	$700,000	$2,025,000
Cash Market Expense	$700,000	$725,000	$775,000	$2,200,000
Futures Mkt Gain (Loss)	$50,000	$50,000	$75,000	$175,000
Actual Cost	$650,000	$675,000	$700,000	$2,025,000
				$6.75 avg. per mmBtu

Case 2 - Falling Prices

What happens to the utility's hedge if prices fall instead of rise?

In that case, assume the market falls to $6.25 in April, $6.50 in May, and $6.75 in June.

	Cash Market	Futures Market
1-Feb		Buys 10 natural gas futures contracts in each of April, May, June for $6.50, $6.75, $7.00, respectively.
27-Mar	Buys 100,000 mmBtu at $6.25	Sells back 10 April contracts, $6.25
26-Apr	Buys 100,000 mmBtu at $6.50	Sells back 10 May contracts, $6.50
26-May	Buys 100,000 mmBtu Mwh at $6.75	Sells back 10 June at $6.75

Financial Result	April	May	June	Quarter
Expected Cost	$650,000	$675,000	$700,000	$2,025,000
Cash Market Expense	$625,000	$650,000	$675,000	$1,415,000
Futures Mkt Gain (Loss)	($25,000)	($25,000)	($25,000)	($75,000)
Actual Cost	$650,000	$675,000	$700,000	$2,025,000

The average cost of $6.75 per mmBtu represents an opportunity cost of 25¢ per mmBtu because cash market prices averaged $6.50 during the period of the hedge. The utility is comfortable with this because it is within the tolerance for risk that the company's risk management committee had set at the time the positions were opened. Managing a hedge strategy is an evolving process. While hedges serve to stabilize prices, risk management targets can be reevaluated in future periods as market and financial circumstances change.

Example 4 - Trucking Company Hedges Diesel Purchases

On September 7, the cash market price of diesel fuel is $2.10 a gallon, exclusive of taxes, a five-cent differential, or basis, to the prevailing exchange heating oil futures price of $2.05.

The trucking company agrees to buy 168,000 gallons of diesel fuel in December at the prevailing futures price plus 5 cents per gallon. On September 7, he buys four December heating oil contracts (42,000 gallons each) at $2.07, the December price quoted that day on the exchange. Total cost: $347,760. If futures prices are unchanged by the time he has to take delivery, his fuel cost will be $2.12 a gallon.

Case 1 - Rising Prices

On November 25, the trucker buys his December fuel allotment of 168,000 gallons in the cash market for $2.15 a gallon, 5 cents over the spot exchange heating oil futures quotation of $2.10. Cost: $361,200.

He sells his four December futures contracts (initially purchased for $2.07) at $2.10 a gallon, the then current price on the exchange, realizing $352,800 on the sale, for a futures market profit of $5,040 (3 cents a gallon).

His effective cost of diesel fuel is $2.12 per gallon or $356,160 (the cash price of the fuel, less his 3 cents gain on the futures, when the contracts rose in price from $2.07 to $2.10).

	Cash Market	Futures Market
Sept. 7		Buy 4 December heating oil futures at $2.07/gal
Nov. 25	Buys 168,000 gallons of diesel fuel at $2.15/gal.	Sells 4 December futures at $2.10/gal.

Case 2 - Falling Prices

On November 25, the trucker buys 168,000 gallons at $2.04 a gallon for a cost of $342,720, the prevailing heating oil futures price of 1.99 cents plus 5 cents a gallon.

He sells his four December futures contracts for 1.99 cents a gallon, realizing $334,320 on the sale, and experiencing a futures loss of $13,440 (8 cents a gallon).

His fuel cost, however, is only 2.04 cents a gallon, 8 cents less than the 2.12 cents that he would have paid had futures prices been unchanged when he entered the hedge. The loss on his futures position is offset by his gain in the physical market.

	Cash Market	Futures Market
Sept. 7		Buy 4 December heating oil futures at 2.07¢
Nov. 25	Buys 168,000 gallons of diesel fuel at 2.04¢/gal.	Sells 4 December futures at 1.99¢/gal.

Hedging Strategies Involving Multiple Contracts

Strip Trades

Strip trading is a flexible strategy that energy futures market participants use when hedging positions for several consecutive months forward. A market participant can lock in an average price for several months at a time by simultaneously opening a futures position in each of the months to be hedged through a single exchange transaction. The average of the futures contracts over the period is the price level of the hedge. A six-month strip, for example, consists of an equal number of futures contracts for each of six consecutive contract months.

Strip trades in futures contracts for crude oil are executed as a single transaction during the open outcry trading session, after being bid and offered at an agreed-upon differential to the previous day's settlement price. The strip and the differential is calculated based on the average value of those months currently versus the average of the previous day's settlement prices for those months.

The ability to obtain an average price for multiple months enables a hedger to average his cash flow over a period of time. Positions can be hedged for as little as two consecutive months, or can go forward for up to 12 months in gasoline; 18 months in heating oil, 30 months in light, sweet crude oil; and 72 months in Henry Hub natural gas.

The futures positions assumed in a strip trade are like any other futures position. Any single month's position can be liquidated by an offsetting futures trade, an exchange of futures for physicals (EFP), or, if desired, physical delivery through the Exchange clearing-house. Strips let a hedger retain the flexibility to change a strategy by buying or selling additional futures contracts in any month, or liquidating the position of any month of the strip, something that cannot be done easily with over-the-counter instruments.

Regular margin requirements apply to strip trades. The participant will be required to post and maintain margin levels for each month in the strip as if it were a separate position.

Example - Petroleum Refiner's Use of a Strip Trade

A refiner anticipates the purchase of 60,000 barrels of crude oil, the volume distributed evenly over a six-month period beginning in October. The use of the strip allows the company to hedge its expenditures for crude oil evenly throughout the period.

The refiner's risk management committee is comfortable with locking in this strip's price level over the period of their purchases, and, considering their fundamental view of the crude oil market, is even willing to pay a higher price, if necessary.

The risk manager determines that those months are currently trading at an average that is 10 cents over the average of the previous day's settlement price, or $68.35. Assuming he wishes to hedge 100% of his physical requirements, he buys 10 contracts for each of the six months, or 60 contracts representing 60,000 barrels since each futures contract is for 1,000 barrels.

The refiner's hedge, which has locked in a price of $68.35 for a total of 60,000 barrels over the period, looks like this:

Month	Transaction Price	Market Position
OCT	$68.54	Long 10 contracts
NOV	$68.42	Long 10 contracts
DEC	$68.35	Long 10 contracts
JAN	$68.29	Long 10 contracts
FEB	$68.26	Long 10 contracts
MAR	$68.24	Long 10 contracts
Average	$68.35

Assuming the refiner takes delivery from its traditional suppliers, it will liquidate the futures positions in the relevant months, offsetting its physical market transactions. If the refiner chooses, however, it can take delivery through the exchange for any, or all, of the months involved in the strategy.

As with any other hedge, there may be a loss in the futures market for a particular month that is compensated for by a gain in the cash market, conversely a gain in the futures market will offset a loss in the cash market.

Regular margin requirements apply to strip trades. The participant will be required to post and maintain margin levels for each month in the strip as if it were a separate position.

Spread Trades

Spread positions offer another way of using futures. There are many types of spreads, but they all have two things in common. First, a spread always involves at least two futures positions, which are maintained simultaneously. For example, a trader may be long 10 June crude oil contracts and short 10 September crude oil contracts. Second, the price changes in the two or more legs of the position are expected to have a reasonably predictable relationship, and the potential profitability of the spread lies in that relationship or expected changes to that relationship. For example, the trader who is long 10 June contracts (the near-term contract) and short 10 September contracts (the distant contract) will benefit if market forces cause the near-term contract to make a larger advance than the more distant contract - or if market forces cause the distant contract to drop more sharply than the near-term contract.

Crack Spreads

A petroleum refiner, like most manufacturers, is caught between two markets: the raw materials he has to purchase and the finished products he offers for sale. It is the nature of these markets for prices to be independently subject to variables of supply, demand, transportation, and other factors. This can put refiners at enormous risk when crude oil prices rise while refined product prices stay static or even decline, thus narrowing the spread.

To calculate the theoretical refining margin, first calculate the combined value of gasoline and heating oil, then compare the combined value to the price of crude. Since crude oil is quoted in dollars per barrel and the products are quoted in cents per gallon, heating oil and gasoline prices must be converted to dollars per barrel by multiplying the cents per gallon price by 42 (there are 42 gallons in a barrel). If the combined value of the products is higher than the price of the crude, the gross "cracking margin" is positive. Conversely, if the combined value of the products is less than that of crude, then the cracking margin is negative.

Using a ratio of two crude to one gasoline plus one heating oil, the gross cracking margin is calculated as follows:

(Assume heating oil is $2.0042 per gallon, gasoline is $2.0801 per gallon and crude is $68.50 per barrel.)
	$2.0042 per gallon x 42 = $84.1764 per barrel of heating oil
	$2.0801 per gallon x 42 = $87.3642 per barrel of gasoline
	The sum of the products is: $174.5406
	Two barrels of crude ($68.50 x 2) = $137.00
	Therefore, $174.54 - $137.00= $37.54
	$37.54/2 = $18.77 (margin)

A refiner expects crude prices to hold steady, or rise somewhat, while products will fall. In this case, the refiner would "sell the crack"; that is, he would buy crude futures and sell gasoline and heating oil futures.

Conversely, buying the crack means buying gasoline and heating oil and selling crude.

Whether a hedger is selling the crack or buying the crack reflects what is done on the product side of the spread.

Once the hedge is in place, the refiner need not worry about movements in absolute futures prices. He need be concerned only with how the combined value of products moves in relation to the price of crude.

The following example shows a refiner locking in a margin between crude oil and heating oil.

Example - Fixing Refiner Margins Through Crack Spreads

In January, a refiner reviews his crude oil acquisition strategy and his potential distillate margins for the spring.

In January, he sees that distillate prices are strong, and plans a two-month crude-to-distillate spread strategy that will allow him to lock in his refinery margins.

On January 22, the spread between April crude ($73 per barrel) and May heating oil ($2.0042 per gallon or $85.76 per barrel) presents what he believes to be a favorable $12.76 per barrel.

The refiner sells the April/May crude-to-heating oil spread, thereby locking in the $2.69 margin.

In March, he purchases the crude for refining into products.

Crude oil futures are $74 per barrel in March, $1 higher than the original crude futures position. Heating oil is trading at $2.0067 per gallon ($84.28 per barrel), which equals a margin of $10.28.

Had the refiner been unhedged, his margin would have totaled only the $10.28. Instead, the net margin from the combination of the futures position and the cash position is the $12.76 he originally sought.

Date	Cash	Financial Effect Futures	Financial Effect Cash	Futures ($/bbl)
Jan.	--	Sell crack spread:
		Buy crude	--	($73.00)
		Sell heating oil at $2.0042/gal.		$85.76
		Net		$12.76
Mar.	Buy crude at $74		($74.00)
	Sell heating oil at $2.0067/gal.		$84.28
	Net		$10.28
		Buy crack spread:
		Sell crude		$74.00
		Buy heating oil at $2.0067/gal		($84.28)
		Net		($10.28)
		Futures gain (loss)		$0.09
	Cash refining margin (loss) without hedge		$10.28
	Final net margin with hedge			$12.76

Purchasing a Crack Spread

The purchase of a crack spread is the opposite of the crack spread hedge. It entails a short hedge in crude oil and long hedges in products. Refiners are naturally long the crack spread as they buy crude and sell products. At times, however, refiners do the opposite, they buy products and sell crude and thus find purchasing a crack spread a useful strategy.

When refiners are forced to shut down for repairs, they often have to enter the crude oil and product markets to honor existing purchase and supply contracts. Unable to produce enough products to meet term supply obligations, the refiner must buy products at spot prices for resale to his term customers. Furthermore, lacking adequate storage space for incoming supplies of crude oil, the refiner must sell the excess on the spot market.

If the refiner's supply and sales commitments are substantial and if he is forced to make an unplanned entry into the spot market, it is possible that prices might move against him. To protect himself from increasing product prices and decreasing crude oil prices, the refiner uses a short hedge against crude and a long hedge against products.