Lesson 7 - Basic Energy Risk “Hedging” using Financial Derivatives

Lesson 7 Introduction

Overview

We've learned that NYMEX energy contracts represent the actual right to buy or sell energy commodities. So, for the commercial market participants, these provide both a market for production and a source of supply. For instance, producers of natural gas, crude oil, or refined products such as heating oil and gasoline, can sell financial contracts, thus guaranteeing that they will have a firm market in the future at a fixed price. Conversely, consumers of these same products can buy contracts to ensure that they will have a firm supply source in the future at a set price. Utilizing financial contracts to reduce price and/or commodity risk is known as "hedging." In this lesson, we will discover the ways in which commercial players in the energy industry use the financial markets for hedging their risks.

Key Learning Points – Energy Risk Hedging

Producers and consumers of energy can reduce both their physical (market or supply) and price risk using financial derivatives such as futures and forwards.
Futures are exchange-traded contracts such as the NYMEX energy commodities: crude, natural gas, heating oil and unleaded gasoline.
“Over-the-counter,” or “OTC” contracts, are known as “forwards.” These are non-exchange traded and can either involve an electronic trading platform or “voice” broker.
Hedgers are not speculators.
In a hedge, commercial participants in financial markets take the opposite position from what they have in the physical markets.
Financial positions must be settled monthly.
Storage capacity can be hedged through buying one month and selling a future month.

Learning Outcomes

At the successful completion of this lesson, students should be able to:

explain how price risk reduction can occur through the use of basic financial derivatives like NYMEX contracts and “basis swaps”;
describe how commodity risk can be reduced;
demonstrate a simple “hedge” structure for:
- energy commodity producers;
- energy commodity consumers;
- storage.

What is due for this lesson?

This lesson will take us one week to complete. The following items will be due Sunday at 11:59 p.m. Eastern Time.

Lesson 7 Quiz
Lesson 7 activities as assigned in Canvas

Questions?

If you have any questions, please post them to our General Course Questions discussion forum (not email), located under Modules in Canvas. The TA and I will check that discussion forum daily to respond. While you are there, feel free to post your own responses if you, too, are able to help out a classmate.

Reading Assignment: Lesson 7

Reading Assignment:

Seng - Chapter 6

Errera & Brown - Chapter 5
This text is available to registered students [1] via the Penn State Library.

Key Points of Emphasis

Hedging reduces both physical and financial risk.
Hedging is performed by commercial entities; it is not "trading."
Hedgers have two positions, one in financial and one in physical.
Hedgers must take an opposite position in the financial market to the one they have in the physical market.
Commodity producers are "long" the physicals and must sell the financials.
Commodity consumers are "short" the physicals and must buy the financials.
Multi-month hedges or "strips" can be obtained.

Reducing Commodity Risk

In Lesson 3, we defined an energy futures contract and the function of the NYMEX. We also identified the two main participants in financial energy markets as “commercial” and “non-commercial” players.

Commercial entities have an interest in the commodity itself due to the particular business they are in. For example, an oil refinery not only needs actual crude oil but also has a stake in the future price of oil. This is the basic feedstock for all of the refined products they produce and, therefore, their profitability is impacted by the purchase price of crude.

In addition, refiners sell products such as gasoline and heating oil, both of which are traded in the financial markets. So, the refiner’s profit is also dependent on the feedstock price for crude and the market price for what it produces.

On the other hand, exploration and production companies need to know the future market price of the crude oil they will extract from their wells.

The same holds true for natural gas. In some cases, natural gas is a component of manufacturing costs in such industries as fertilizers and food processing. In the power industry, the price of natural gas impacts the cost of generating electricity. And for midstream processors, natural gas is the main component for the extraction of valuable natural gas liquids (NGLs).

E&P companies that produce natural gas can also see the future market prices for their production.

Keeping in mind that futures contracts are legally binding obligations to buy or sell a commodity, they guarantee a market for producers and a source of supply for consumers. They also guarantee a set or “fixed” price, thereby reducing price risk as well.

In Lesson 4, we learned about the spot market (it is also called the physical market, or the cash market), as the market where the actual physical commodity is traded. Local spot market price is determined by the local supply and local demand, and it can become very volatile because local supply has to be planned by the producers in advance and producers don’t know the exact demand ahead of time. The difference between financial and physical market prices is called basis.

The effectiveness of hedging is highly dependent on the relationship between futures and spot market prices. This relationship can be explained by parallelism and convergence.

Parallelism represents the close relationship between futures and spot market prices, and the fact that both are influenced by similar factors. Parallelism explains the fact that futures and spot market prices track each other (they are highly correlated). The fact that futures contract price tends to get very close to the cash market price is called convergence.

Simple Hedging

Commercial parties could enter the financial energy marketplace to reduce their supply and/or price risk. For instance, a producer has a commodity and needs a market. In the futures market, they will sell contracts and thus create a future market for their natural gas, crude, etc. This guarantees that a counterparty will take their production and will do so at a known, fixed price. Consumers of energy do not have the commodity. Therefore, they can buy contracts in the futures markets. For them, this guarantees that a counterparty will provide the commodity and will do so at a known, fixed price.

ExxonMobil, the largest producer of natural gas in the US, wishes to sell some of its production for December at the current market levels since those prices help them meet earnings targets. To mitigate the price risk that can occur between now and December, they will sell the financial NYMEX contracts. Thus, they are guaranteed a market at Henry Hub at a fixed price when the December production month comes around. They can do this for any month up to the 118 months that the Natural Gas contract trades.

In the case of a natural gas midstream company engaged in the gathering and processing of natural gas, their profit depends on the changes of the price of natural gas (their feedstock) and the natural gas liquids (NGLs) that they produce. Let's say they are concerned about rising natural gas prices. They can buy December contracts and thus be guaranteed supply at Henry Hub at a fixed price when the December production month comes around.

In each of the above cases, the counterparty to the contracts will be responsible for delivering or taking the crude oil at Cushing, OK or, the natural gas at Henry Hub, LA. Per the NYMEX contracts, this is legally binding. That is what guarantees both the supply & market as well as the price.

Simple Hedging

Physical players (commercial parties active in the spot market) are subject to price risk in the spot market. They can take a financial position which is opposite to their physical position, in order to mitigate the price risk. This is called simple hedging. This is much the same as one who bets on the “favorite” in a horse race, but “hedges” that bet by also placing bets on another possible winner. They hope to mitigate their losses should the favored horse not win.

Futures prices, for any commodity, are deemed to represent the “market” as it is known at the moment. (We also addressed, in Lesson 3, the idea of the “price discovery” that futures markets provide.) A producer is considered to have sold “at market” at the time they enter into futures contracts. But we know that prices will change between the time this deal was transacted and the time the actual commodity changes hands. This fluctuation will impact the perception of the actual cash price until the delivery month arrives and the “real” price is established through physical, cash, trading (as reflected in the cash price "postings" we spoke about in Lesson 4). (The fluctuation of cash and futures throughout the life of the contract is known as, "parallelism"). Cash and futures prices tend to approximate one another at the "settlement" of the financial contracts, thus, allowing them to move "in sync". This concept is called "convergence".

In Lesson 3, we also said that less than 2% of all futures contracts actually go to delivery, that is, the physical commodity does not usually change hands as a result of the financial transactions. (Think about the non-commercial players. They neither have, nor want, the actual physical commodities. They are just trading price.) So, how does this “hedging” work?

Mini-lecture: Simple hedge using futures contracts (6:20 minutes)

Simple hedge using futures contracts mini-lecture

Click for a transcript

If you own or work for an oil-producing company, you know that you’re going to produce crude oil over time. You know that you’re going to have production in April, May, November, and December. But you’re concerned about the price. If the price goes up, then you will make more money. If the price goes down, you will lose.

On the other side, let’s say you own an oil refinery. You know you are going to need crude oil for November and December, so you have to buy that. You have to pay for that. If the price goes up, you start losing money. If the price goes down, you make money, fortunately, but that’s not always the case. That’s where hedging is going to help to reduce the risk and mitigate, and sometimes remove, the risk.

What you can do is go to the financial market, to the NYMEX, and get the futures contract for delivery in November or December, whenever you want it. If you’re a crude oil-producing company, you know you have to take your position. If you’re a crude oil refinery, you will be needing crude oil. You have to go and take a long position. But remember, these contracts are binding.

If you own an oil-producing company, you have to go to Cushing and deliver it there at the time. If you have a long position by the expiration date, you have to take the delivery from Cushing. That’s the location under the contract binding.

Let’s say you have an oil refinery or a crude oil company that is not close to Cushing, or you are not interested in working with Cushing, taking delivery, or delivering it to Cushing. The good news is you can still use this futures contract with a tweak called simple hedging. We’ll go through that right now and walk through some examples.

This is the same for natural gas companies. If you own a natural gas-producing company or a power plant that needs natural gas, you have to buy and are very concerned about the price fluctuation. You want to mitigate that risk and reduce your risk exposure. We’ll see how we can use these futures contracts, a combination of futures contracts, which is called a simple hedge.

Remember, you are operating in some local spot market. As we learned in lesson four, the local prices are going to be more volatile compared to the futures prices. Why? Because they are being affected by the local supply and local demand. Any small fluctuation in supply and demand will change the local price immediately. Local prices, or spot prices, are going to be more volatile. By volatile, I mean more variation in the price compared to the financial market.

A perfect hedge or simple hedging strategy is going to be taking two equal but opposite positions in the cash market and the futures market. A producer will be long in the cash market. A producer is always long commodity because a producer always has the commodity, always has crude oil to sell. So, a producer is going to be long in the cash market and has to take a short position in the futures market. This is called a short hedge.

On the other side, a consumer, let’s say an oil refinery, is always in need of crude oil. An oil refinery is short commodity; it’s always short in the cash market, in the spot market, in the physical market. So, a refinery should take a long position in the futures market. This is called hedging. We’ll walk through some examples and see how this hedging strategy can eliminate or significantly reduce the risk exposure of these two players.

The only difference between a perfect hedge and an imperfect hedge is that a perfect hedge entirely eliminates the risk. An imperfect hedge, which is more realistic, does not fully eliminate but substantially reduces the risk exposure. An efficient hedge is highly dependent on the relationship between the futures and spot markets. Because these two are highly correlated, we can see gain and loss in one market will offset all or some of the loss or gain in the other market.

Simple Hedging

Commercial parties could enter the financial energy marketplace to reduce their supply and/or price risk.

For instance, a producer has a commodity and needs a market. In the futures market, they will sell contracts and thus create a future market for their natural gas, crude, etc.

This guarantees that a counterparty will take their production and will do so at a known, fixed price. Consumers of energy do not have the commodity.

Therefore, they can buy contracts in the futures markets. For them, this guarantees that a counterparty will provide the commodity and will do so at a known, fixed price.

In the case of a natural gas midstream company engaged in the gathering and processing of natural gas. Their profit depends on the changes in the price of natural gas that is their feedstock and the natural gas liquids (NGLs) that they produce.

Let’s say they are concerned about rising natural gas prices. They can buy December contracts and, thus, be guaranteed supply at Henry Hub at a fixed price when the December production month comes around.

In each of the above cases, the counterparty to the contracts will be responsible for delivering or taking the crude oil at Cushing, OK or the natural gas at Henry Hub, LA. Per the NYMEX contracts, this is legally binding. That is what guarantees both the supply & market as well as the price.

In Lesson 3, we also said that less than 2% of all futures contracts actually go to delivery, that is, the physical commodity does not usually change hands as a result of the financial transactions. (Think about the non-commercial players. They neither have, nor want, the actual physical commodities. They are just trading prices.) So, how does this “hedging” work?

Hedge includes taking two equal but opposite positions in the cash and futures market.

In that case, gain and loss in one market is offset by loss and gain in the other market, and the hedger’s risk exposure will be reduced or eliminated.

More on Hedging

As we learned in the previous pages, gain, and loss in hedging depends on the basis.

Predicting the behavior of the basis could create an opportunity for making profit.

This is called arbitrage hedging.

For example, from the concept of convergence, we can predict the basis to narrow over time.

In a contango market, basis narrows with respect to the storage cost per time. However, in an inverted market, basis narrows at the expiration date, but this rate is unpredictable.

Credit: Farid Tayari

Perfect Hedge

Hedge includes taking two equal but opposite positions in the cash and futures market. In that case, gain and loss in one market is offset by loss and gain in the other market and the hedger’s risk exposure will be reduced or eliminated.

Perfect Hedge

1. Seller's hedge or short hedge

Assume the current spot market price for crude oil is $60/bbl. A crude oil producer is planning to sell 500,000 barrels of crude oil in the cash market in December (they are said to be “long” the commodity). As we learned in Lesson 4, commodity prices in the spot market (cash or physical market) are affected by the local supply and demand. Consequently, spot market prices are more volatile than the futures prices and the producer is subject to price risk until December.

Assume the current NYMEX December futures market price is $61.00. In order to hedge the December price against the price fluctuations, the crude oil producer has to take the short position (the opposite of the physical position) in the financial market and sell 500 December crude oil contracts. When the hedger has the long position in the spot market and the short position in the financial market, it is called seller's hedge or short hedge. In this case, the price is now set at $61.00 for December delivery of West Texas Intermediate Crude Oil at the Cushing, OK, Hub.

However, the crude oil producer is intending to sell the product in the spot market and not interested in delivering the crude oil at the Cushing, OK, Hub. And remember that all December futures contracts must be financially settled at the end of November according to the rules of the exchange. So, by the end of November, the producer must buy back the contracts in order to balance their financial position (close the position). Remember, if producer doesn't close the financial position, they have to deliver the crude oil to Cushing, OK, Hub.

So, what happens to the price that the producer will receive when they actually sell their crude oil in the December cash market? Since the futures pricing represents the “market,” the December futures prices rose and fell as the contracts traded. Both the value of the futures contracts that the producer sold, as well as the cash price (market), fluctuated throughout the life of the December futures contract trading. When the producer had to buy back the futures contracts on final settlement day, if the contract price had risen, they took a loss on their financial transaction. But what happened in the cash market? Since futures rose, so did cash, thus providing a gain in the physical market for the producer. Conversely, if futures prices had fallen by final settlement, the producer would’ve paid less for buying the futures contracts back and made a profit on the financial transaction. However, since the futures market declined, so did the cash market, thus lowering the actual price the producer received when the December crude oil production was sold in the physical market.

In both of these scenarios, the gain or loss in the financial market is offset by a corresponding and opposite gain or loss in the physical cash market. If the spot and financial markets move exactly in tandem, this results in a perfect hedge. We refer to a “perfect” hedge when there is a 1:1 correlation between the financial and physical markets.

Example 1: Assume the price has gone down. On November 1st the spot market prices are $59.3/bbl and in that case (assuming perfect hedge) the December futures contract would be $60.30/bbl.

Example 1
Date	Cash Market	Financial Market	Net
Now	Long Price = $60/bbl	Short Producer sells 500 December contracts Price = $61/bbl
November 1st	Price = $59.30/bbl Loss = (59.30-60)*500,000 = - $350,000	Close the position: Producer buys 500 December contracts Price = $60.30/bbl Profit = (61-60.30)*500,000 = $350,000	-$350,000 + $350,000 = 0

In this case, the loss in the spot market is offset by the profit in the financial market.

Example 2: Assume the price increased and on November 1st the cash prices are $60.50/bbl. In that case (assuming perfect hedge) the December futures contract would be $61.50/bbl.

Example 2
Date	Cash Market	Financial Market	Net
Now	Long Price = $60/bbl	Short Producer sells 500 December contracts Price = $61/bbl
November 1st	Price = $60.50/bbl Profit = (60.50-60)*500,000 = $250,000	Close the position: Producer buys 500 December contracts Price = $61.50/bbl Loss = (61-61.50)*500,000 = - $250,000	$250,000 + (-$250,000) = 0

As we can see in the above table, the profit in the spot market is offset by the loss in the financial market.

Mini-lecture: Short hedge (seller’s hedge) (10:51 minutes)

Short hedge (seller’s hedge) mini-lecture

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So we learned that a perfect hedge is when the hedge completely eliminates the gain and loss in the market due to the price fluctuations. We started this with this example and said, "Okay, assume you work for an oil-producing company and you know that you're going to have your production plan and you know you're going to have $500,000 of crude oil for the market in December. Right now, let's say it's March. You know that you're going to produce around $500,000 of crude oil in the market in December. So your position in the cash market is going to be long. Always, it is going to be long. You're going to be long commodity in the cash market. So the hedging strategy is you have to go to the financial market and sell how many? 500 contracts right now in March, right? Let's go through some numbers here. Let's assume the current price in the spot market is $60 per barrel. December futures contract delivering in December is $61, right? So you will go and sell 500 futures contracts expiring in December right now, right?

And let's say time passes and we are getting close to December. It's November, early November. Price changes, and in this scenario, prices go down. Prices go down in the financial market and also go down in the spot market. Why? Because we said the relationship between the spot market and futures can be explained in two terms. One term is when the financial market and the spot market are highly correlated. They track each other. They are being affected by the same factors. One goes up, the other goes up. One goes down, the other goes down too. And the other term is convergence. Convergence is for the expiration date. When we get close to the expiration date, these two prices, financial market and futures, get close to each other. They converge under this scenario. So we'll see that it's early November. It is still some time to the expiration date, but prices have gone down.

Okay, I'm trying to put the pen. So the spot market has gone down 70 cents. You remember in March it was $60. Right now it's $59.30, 70 cents. And also in the financial market, prices have gone down too. It was $61 early on in March when we sold December futures at $61, and right now prices have gone down and it is $60.30, right? So this is how we set up the table. As you can see, early on in March, the price in the cash market was $60. So we went to the financial market and we shorted 500 futures contracts expiring in December at $61, right? Time passes. It's early November. Prices go down 70 cents in the cash market, 70 cents in the futures market, and because we are not interested in delivering the commodity to Cushing, Oklahoma, we have to close our position in the financial market. Now we are going to calculate the money that we lose in each market.

So we learned that because prices have gone down in the cash market, we're going to lose some money in the cash market, right? We are producers. We aimed for $60. Now prices have gone down to $59.30. How much money do we lose in the cash market? $500,000 of crude oil times this difference, $59.30 minus $60, times $500,000, which is going to be minus $350,000. How much do we gain or lose in the financial market? You remember the position is short. We sold the contracts at $61. Price went down from the fundamental factors. We know that if we take a short position, we will make money if the market is bearish, right? So we sell high, we buy low. How much money do we make? The difference, right? It is going to be 70 cents, the difference between these two, times 500,000 barrels, 500 contracts, 1,000 barrels each contract. So it is going to be 500,000 barrels. So we're going to make a profit of $350,000. And as we can see, these two are exactly equal, so the net is going to be zero. This is called a perfect hedge, right? When what we lose or gain in one market equals what we gain or lose in the other market.

Okay, let's work on another example here. We assume from now to November prices went down. Prices go down. Let's assume the other way. Let's assume from now to November prices go up. Let's see what happens. In this example, we saw how hedging was successful in helping us make up the money that we lost in the cash market, right? Okay, another example. Let's say prices go up. Prices go up to $60.50 in the cash market and $61.50 in the futures, right? Again, we set up the table. In March, right now, the price in the cash market was $60. We had 500,000 barrels of crude oil, and the position was short $61. Sorry, this should be $61. I should correct this. I think I missed that. Slide number 41. Okay, so the price was $61. The position was short. Now time passes. It's November. Prices go up 50 cents here, 50 cents here. Let's see how much money we make or lose in the cash market. So prices go up, right? And we are producers. We are crude oil producers. When prices go up, we make money, 50 cents. How many barrels? 500,000 barrels. So we are going to make $250,000 in the cash market. How about in the financial market? Prices go up, right? 50 cents go up. The position was short. From the fundamental factor, we know that if we have a short position, if the market is bullish, if prices go up, we lose money, right? How much? The difference times the barrels that we are going to have in the market. How much do we lose? $250,000. Again, in this case, these two gain and loss, they match, and we end up losing nothing, gaining nothing. Very important point here. If there was no hedging strategy, we could have made $250,000 because prices went up. Now, because we are obligated under this hedging strategy, because we shorted 500 contracts, we are obligated to close the position, and we lose money. So because we hedged, we lose money. If there was no hedging, there was no loss here. But remember, hedging is not only about getting rid of potential loss. Hedging is when you are going to say, "Okay, I don't want any deviation in my revenue. I'm going to stay with what I plan, and I am willing to get rid of potential profit as well as potential loss." So this is what we see here. If there was no hedge, you could have made $250,000. But when you are in March, you don't know what is going to happen in November. So you say, "Okay, I don't want to risk that. I could make money, or I could lose money. I'm going to get rid of both." In this case, we can see under this scenario, we could have made money, but because we are under this hedge, then we lost some money under the hedge, but they cancel out the job.

Perfect Hedge - Seller's Hedge or Short Hedge

Let's assume a crude oil producer is planning to sell its product of 500,000 barrels of crude oil in the cash market in December.
They are said to be "long" the commodity.
Producer sells 500 December futures contracts.
In this case, the price is now set at $61.00 for December delivery of West Texas Intermediate Crude Oil at the Cushing, OK, Hub.
Producer sells 500 December futures contracts.
The price is now set at $61.00 for December delivery of West Texas Intermediate Crude Oil at the Cushing, OK, Hub.

Perfect Hedge - Seller's Hedge or Short Hedge
Date	Cash Market	Financial Market
Now	Long Price = $60/bbl Producer sells 500 December contracts	Short Price = $60/bbl Producer sells 500 December contracts
Nov. 1st	Price = $60.50/bbl Profit = (60.50 - 60) * 500,000 = $250,000	Close the position: Producer buys 500 December contracts Price = $61.50/bbl Loss = (61 - 61.50) * 500,000 = -$250,000
Net: $250,000 + (-$250,000) = 0

The profit in the spot market is offset by the loss in the financial market.

Credit: Farid Tayari

2. Buyer's hedge or long hedge

Assume a refinery is planning to buy the same amount of crude oil in the same spot market and the refinery wants to hedge the December price and its profit against the price fluctuations. The refinery is said to be “short” the commodity and having the short position in the spot market. In order to hedge, the refinery has to buy 500 December futures contracts (1000 bbl each) in the financial market and sell them by the end of November (closing position). This is called buyer's hedge or long hedge, which is opposite to the seller's hedge.

Example 3: Assume on November 1st, the spot market prices are $59.3/bbl and in that case (assuming perfect hedge) the December futures contract would be $60.30/bbl.

Example 3
Date	Cash market	Financial Market	Net
Now	Short Price = $60/bbl	Long Refinery buys 500 December contracts Price = $61/bbl
November 1st	Price = $59.30/bbl Profit = (60-59.30)*500,000 = $350,000	Close the position: Refinery sells 500 December contracts Price = $60.30/bbl Loss = (60.30-61)*500,000 = - $350,000	$350,000 + (-$350,000) = 0

The profit in the spot market is offset by the loss in the financial market.

Example 4: Assume prices increased and on November 1st the cash prices are $60.50/bbl and in that case (assuming perfect hedge) the December futures contract would be $61.50/bbl.

Example 4
Date	Cash Market	Financial Market	Net
Now	Short Price = $60/bbl	Long Refinery buys 500 December contracts Price = $61/bbl
November 1st	Price = $60.50/bbl Profit = (60-60.50)*500,000 = -$250,000	Close the position: Refinery sells 500 December contracts Price = $61.50/bbl Loss = (61.50-61)*500,000 = $250,000	-$250,000 + $250,000 = 0

As we can see in the above table, the refinery's loss in the spot market is offset by the profit in the financial market.

Note that based on the concept of "convergence", getting close to the expiration date, the final settlement price for the December crude oil contract on the NYMEX would represent the cash market price for that month.

This process can be performed many times over by the producers and consumers as desired. Thus, suppliers and end-users can establish a fixed-price and hedge against the price fluctuations. And theoretically, they can do so for as many future months as the particular contact allows (this is dependent on the number of market participants willing to trade that far out).

Mini-lecture: Long hedge (buyer’s hedge) (5:23 minutes)

Long hedge (buyer’s hedge) mini-lecture

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We have the same concept for the buyers, right? Buyers, let's say a refinery. A refinery is going to need crude oil as the raw material, right? So, because a buyer is always short in the cash market, they have to take the opposite position in the financial market, which is the long position. That's why this is called a long hedge, right?

Okay, let's work on an example. Same example, let's say you work for a refinery. Right now it's March. The price in the spot market is $60. The financial market delivering in December is $61. Time passes. Early November, prices go down. Prices go down 70 cents in each market, spot market, and financial market.

We set up our table. This is the table, and let's calculate how much we make or lose in the cash market and the financial market. So, as a refinery, you are a buyer, right? So, if prices go down, you aim for $60. Right now, 70 cents less, so you end up paying less money, so you actually make money. How much? The difference between these two times the quantity of oil, the volume of oil that you will need. How much? That is going to be the difference times $500,000. So, you are going to end up making $350,000 because you took a long position in March, right? And you have to close your position in early November. Prices go down. The position was long. From a fundamental factor, we know that if you take the long position, if the market is bearish, if prices go down, you lose money because you buy high and sell low, right? How much? Minus $350,000. And again, under this scenario, you see that if there was no hedging, we could have made $350,000. But because we hedged, we are obligated under this futures contract. We have to close the position. When we close, we lose money in closing. But when it's March, you don't know what is going to happen in December. So, you say, okay, you know what, I'm going to get rid of potential loss and potential profit. In this case, you get rid of potential revenue. If you know for sure the market is going to be bearish, then you should not get involved in any hedging, right?

Okay, the other example, assuming that the market is going to be bullish. So, prices go up 50 cents in each market. We'll set up the table. March, spot market $60, futures market December $61. Then time passes, prices go up, the market is bullish, 50 cents in each market. We end up losing money in the cash market because we planned for $60. Then prices go up, we need to buy at a higher price, so we lose $250,000 in the cash market. Financial market, what happens? We took a long position. The market is bullish, so a long position in a bullish market makes money. How much? The difference times the contracts that we have. We have 500 contracts, $1,000 each. It is going to be 500 times the difference, so we'll make $250,000. And as you can see, the net here is zero. What we make in one market cancels out whatever we lose in the other market. Here, hedging is perfect. So, we were covered. We made some money that covered some of the extra expenses that we had in the cash market.

Okay, so this was a perfect hedge when gain and loss in one market eliminates gain and loss in the other market. This is a bit... In reality, they don't exactly... The spot market and financial markets are highly correlated, but the changes are not exactly the same. You see here, 50 cents here, 50 cents. These are not exactly 50 cents. So, in that case, what creates the situation is going to be called imperfect hedge. Everything else is very similar to here. The hedging strategy is very similar, but the net is not going to be zero because the change is not exactly the same. Still, they are highly correlated. Still, if one goes up, the other goes up. If one goes down, the other goes down, but not exactly the same, you know?

Credit: Farid Tayari

Imperfect Hedge

As we learned previously, the perfect hedge can remove the price risks for sellers and buyers in the spot market. In the perfect hedge, we assume spot and financial market move exactly in tandem and prices in both markets are perfectly correlated, which means the case basis (the difference between spot and futures prices) stays unchanged. However, this assumption is not very realistic. Spot and futures market prices are highly correlated (parallelism) but the correlation is not usually perfect and basis changes over time. In that case, hedging is still effective, but it doesn’t eliminate the price risk. The hedger’s gain and loss in the spot and futures market are not fully offset, and the hedger will end up with some gain or loss. This is called imperfect hedge. Note that the gain or loss of hedging will be much less than not utilizing hedge.

1. Seller's hedge or short hedge

Following the example from the previous page, assume the price has gone down between the time of selling the futures contract and November 1st and the basis has changed a bit (imperfect hedge). Let's explore two cases:

On November 1st, the spot market prices are $59.5/bbl and the December futures contract would be $60.60/bbl.
On November 1st, the spot market prices are $59.60/bbl and the December futures contract would be $60.40/bbl.

Example 5: On November 1st, the spot market prices are $59.50/bbl and the December futures contract would be $60.60/bbl.

Example 5
Date	Cash Market	Financial Market	Net
Now	Long Price = $60/bbl	Short Producer sells 500 December contracts Price = $61/bbl
November 1st	Price = $59.50/bbl Loss = (59.50-60)*500,000 = - $250,000	Close the position: Producer buys 500 December contracts Price = $60.60/bbl Profit = (61-60.60)*500,000 = $200,000	-$250,000 + $200,000 = -50,000

Example 6: November 1st the spot market prices are $59.60/bbl and the December futures contract would be $60.40/bbl:

Example 6
Date	Cash Market	Financial Market	Net
Now	Long Price = $60/bbl	Short Producer sells 500 December contracts Price = $61/bbl
November 1st	Price = $59.60/bbl Loss = (59.60-60)*500,000 = - $200,000	Close the position: Producer buys 500 December contracts Price = $60.40/bbl Profit = (61-60.40)*500,000 = $300,000	-$200,000 + $300,000 = 100,000

As the results show, gain or loss in the spot market are not fully offset by the loss or gain in the financial market. But hedging is still effective in reducing the risk.

Now, let's assume the price goes up from the time of selling the futures contracts in NYMEX to November. We consider two cases:

Mini-lecture: Short hedge (seller’s hedge) imperfect hedge example (8:08 minutes)

Short hedge (seller’s hedge), imperfect hedge example part 1 mini-lecture

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The imperfect hedge, which is a more realistic case. So, same examples but different prices, different scenarios. The structure of an imperfect hedge is very similar to the perfect hedge. The only difference is the change in the prices in the financial and futures markets are not going to be exactly the same. So, we are going to have eight examples: four for short hedger, four for long hedger.

Now, let's walk through the first four examples. Again, let's assume you are working for an oil-producing company. It's early March. You know that you're going to have 500,000 barrels of crude oil ready for the market in December. Right now, the cash market price is $60. The futures delivering in December is $61. And you are a producer, so you're going to be long in the cash market. So, you have to take the opposite position in the futures. Your position is going to be short in the futures. You go and sell 500 contracts expiring in December in the futures market.

Let's start with the first example. Let's assume time passes, and prices go down. Right, first two scenarios, prices go down. Here we can see the spot market goes down 50 cents. The spot market goes down 40 cents. So, it was $61 minus 40 cents, it is $60.60. The second example, which we will get to after a couple of slides, prices still go down, but the change in the futures market is larger than the spot market. You can see the spot market price drops 40 cents, futures price drops 60 cents.

Right now, let's work on the first example. So, price drops in both markets, but in the spot market, it drops a bit more than in the financial market. Okay, so here's the table. Today, it's March. Spot price is $60. December futures are going to be $61. So, we take a short position, 500 contracts delivering in December, right? This is the hedging strategy. Time passes. The market is bearish. Price drops. Price drops 50 cents in the cash market and 40 cents in the financial market.

How much do we lose in the cash and the financial market? How much are the gain and loss in the cash and financial market? So, here we can see we aimed for $60. Now, the price drops. We are sellers, so we make less money. Price is down. How much money do we lose? The difference between these two, right? 50 cents times 500,000 barrels of crude oil, right? So, this is going to be 50 cents times 500,000 barrels of crude oil, and it is going to be $250,000.

What happens in the financial market? That was the loss, right, negative. Do we make or lose money in the financial market? Short position, bearish market, making money. How much? The difference. We sell at $61, we buy at $60.60. How much do we make? We make 40 cents, the difference between these two, times 500 contracts. So, this is a gain, 40 cents times 500 contracts. And what is the net? 500,000 barrels of crude oil, right? So, I have the calculations here. We lost $250,000 in the cash market. We gained $200,000 in the financial market. So, the net is minus $50,000, right? So, in this hedging strategy, we ended up losing $50,000, right? So, hedging is still efficient. It didn't eliminate the entire loss, but as you can see, this minus $50,000 is a lot less than minus $250,000. Under this hedge, we still lost some money, but this is far less compared to minus $250,000, right? So, hedging is still effective. The net is not zero. We lost some money, but this is far less than if we were not hedged.

Second example. Prices drop. Still, the market is going to be bearish, but it drops less in the cash market. Cash market is $60. Right now, it drops 40 cents going to November. Futures, right now, is $61. Then it drops to $60.40. So, in futures, it drops 60 cents. Setting up the table, right now, $60 going down to $59.60 in the cash market. Do we make money or lose money? We lose money. We are sellers. Price goes down, we get less money. How much? The difference between these two, which is going to be 40 cents times these 500,000 barrels of crude oil, which is going to be $200,000.

Financial market. Do we lose or gain money? Short position, bearish market, so we gain money. How much? The difference between when we open the position compared to when we close the position. This difference is 60 cents. How much money do we make? 60 cents is the difference times 500,000 barrels. I have the calculations here. We lost $200,000 in the cash market. We gained $300,000 in the futures. Under this hedge, what is the net? $100,000. So, in this case, we ended up making money. Under this hedging, we are protected against this loss and also made some extra cash.

Credit: Farid Tayari

On November 1st, the cash prices are $60.35/bbl and the December futures contract would be $61.50/bbl.
On November 1st, the cash prices are $60.50/bbl and the December futures contract would be $61.40/bbl.

Example 7: November 1st, the cash prices are $60.35/bbl and the December futures contract would be $61.50/bbl.

Example 7
Date	Cash Market	Financial Market	Net
Now	Long Price = $60/bbl	Short Producer sells 500 December contracts Price = $61/bbl
November 1st	Price = $60.30/bbl Profit = (60.35-60)*500,000 = $175,000	Close the position: Producer buys 500 December contracts Price = $61.50/bbl Loss = (61-61.50)*500,000 = - $250,000	$175,000 + (-$250,000) = -75,000

Example 8: November 1st the cash prices are $60.50/bbl and the December futures contract would be $61.40/bbl.

Example 8
Date	Cash Market	Financial Market	Net
Now	Long Price = $60/bbl	Short Producer sells 500 December contracts Price = $61/bbl
November 1st	Price = $60.50/bbl Profit = (60.50-60)*500,000 = $250,000	Close the position: Producer buys 500 December contracts Price = $61.40/bbl Loss = (61-61.40)*500,000 = - $200,000	$250,000 + (-$200,000) = 50,000

Mini-lecture: Short hedge (seller’s hedge), imperfect hedge example (5:00 minutes)

Short hedge (seller’s hedge), imperfect hedge example part 2 mini-lecture

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Now let's move on to the case. Still, we are talking about the seller's hedge, but in this case, the market is going to be bullish, right? Example three and example four. In both cases, prices go up. In one, cash prices go up smaller than the futures, and in the other one, cash prices go up larger than the futures, right?

Example three. It is going to be a seller's hedge or short hedge. It is early March. The spot price is $60. Futures delivering in December is $61. The market is bullish. Prices go up. It goes up 35 cents in the cash market, but it goes up 50 cents in the futures market. We set up the table. This is the hedging strategy. Again, we are going to be long in the cash market, so we take a short position in futures. The market is bullish. Prices go up. Sorry, this is a typo. This should be 35 cents. So, this is what we made in the cash market. This is what we lost in the futures market, and this is the net. As you can see, under this scenario, under this hedging strategy, we ended up losing a little bit of money, $75,000. And again, remember, because we are obligated to close these positions, we lost this $250,000 in the financial market. If we had known that the market was going to be bullish, there was no need for hedging because we didn't know what was going to happen in November. We got into the hedge, and right now, we got stuck, and we have to pay $250,000. If there was no hedging, we could have made $175,000 more, and right now, because under this hedge, we ended up losing $75,000.

Okay, the fourth example. The market is still going to be bullish, but what happens here is the increase in the cash price is going to be higher compared to the futures. So, prices go up 50 cents in the cash market but only 40 cents in the futures. We set up the table. Right now, the cash market is $60, and futures delivering in December is $61. Time passes. It's early November. The market is bullish. Prices have gone up 50 cents in the cash market and 40 cents in the financial market.

So, do we make money or lose money in the cash market? Prices go up. We are sellers, so we are going to make more money, right? So, how much? The difference between these two, which is 50 cents, times the amount of oil that we have, which is 500,000 barrels. We make more money in the cash market. Financial market. Do we lose money or make money? Short position, bullish market, we lose money. How much? The difference between these two, which is 40 cents, right? 40 cents times the 500 contracts times 1,000 barrels each. So, here we make $250,000 in the cash market and lose $200,000 in the financial market. What is the net? The net is positive, slightly positive, right? Again, here, because we are under this hedging, we are obligated to close the position. We lose the money in the financial market. If there was no hedging, if the company was fully exposed to any risk, then we could have made $250,000, but we lost $200,000 of that in the financial market.

Credit: Farid Tayari

2. Buyer's hedge or long hedge

Following the example from the previous page, assume prices have gone down from the time the refinery buys the future contracts until November 1st. Let's consider the above cases:

On November 1st, the spot market prices are $59.50/bbl and the December futures contract would be $60.60/bbl.
On November 1st, the spot market prices are $59.60/bbl and the December futures contract would be $60.40/bbl.

Example 9: On November 1st, the spot market prices are $59.50/bbl and the December futures contract would be $60.60/bbl.

Example 9
Date	Cash Market	Financial Market	Net
Now	Short Price = $60/bbl	Long Refinery buys 500 December contracts Price = $61/bbl
November 1st	Price = $59.50/bbl Profit = (60-59.50)*500,000 = $250,000	Close the position: Refinery sells 500 December contracts Price = $60.60/bbl Loss = (60.60-61)*500,000 = - $200,000	$250,000 + (-$200,000) = 50,000

Example 10: On November 1st, the spot market prices are $59.60/bbl and the December future contract would be $60.40/bbl.

Example 10
Date	Cash Market	Financial Market	Net
Now	Short Price = $60/bbl	Long Refinery buys 500 December contracts Price = $61/bbl
November 1st	Price = $59.60/bbl Profit = (60-59.60)*500,000 = $200,000	Close the position: Refinery sells 500 December contracts Price = $60.40/bbl Loss = (60.40-61)*500,000 = - $300,000	$200,000 + (-$300,000) = -100,000

Mini-lecture: Long hedge (buyer’s hedge), imperfect hedge example (6:32 minutes)

Long hedge (buyer’s hedge), imperfect hedge example, part 1 mini-lecture

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Buyer's hedge or long hedge. A buyer is short in the physical market, in a spot market, so the buyer should take the opposite position, which is long in the financial market. Working with the same example, let's assume that you work for a refinery that will need, that will know in December, the refinery will need 500,000 barrels of crude oil. They have to buy 500,000 barrels of crude oil from the cash market in December. So the hedging strategy is they have to take a long position right now in March, or whenever it is right now, and wait until before December.

So, for example, this is, let's say, example five. Under this scenario, we'll have four scenarios. The first scenario, example five, is when prices go down. The first scenario, it goes more down in the spot market compared to the futures. The second scenario is the opposite.

Okay, so we set up the table. Right now, in March, the cash market price is $60. We know that the buyer is always short in the spot market, so buyers should take a long position in the financial market. So the buyer will buy 500 December futures contracts from the financial market. The price is $61 right now. Time passes. It's early November, and so what happens when prices go down? Do buyers make or lose money in the cash market? Because the price goes down, they pay less money in the cash market, so they end up making some money in the cash market. How much? 50 cents per barrel. So it is going to be 50 cents per barrel. They make money in the cash market, make more money because they have to pay less, and they will need 500,000 barrels.

Financial market. Do they lose money or make money? We know that a long position loses money in a bearish market. The market is bearish from now to November, so they lose money in the financial market. How much? The difference between these two, which is 40 cents, times the amount of 500 contracts, a thousand barrels each. So they end up losing $200,000. So they make $250,000 more in the cash market. They lose $200,000, and as you can see, they still end up making a little bit more. The net is not zero, it is a bit more, but under this hedging strategy, they lost money in the financial market, right? Again, the important thing here to remember is because they were under this hedge, they lost money in the financial market. In this scenario, if there was no hedging, they could have made $250,000. But when you are hedging for some time in the future, you don't know what is going to happen in November, right? That's why you hedge.

Okay, the next example. Again, the market is going to be bearish, but changes in the spot market are going to be less than changes in the futures market. Let's see what happens. We set up the table again. Right now, the cash market crude oil price is $60. The financial market delivering in December is $61. The market is bearish moving on to November. Prices drop 40 cents in the cash market, but it drops 60 cents in the futures market. Early November, the contract expires in December, so we have to close our position.

Do we make money or lose money in the cash market? Prices go down. We are buyers. We have to pay less, so we end up making some money because we paid less. How much? 40 cents. 40 cents, and there will be 500,000 barrels of crude oil that we'll need, so we'll make $200,000 in the cash market. We pay less, $200,000.

Financial market. Do we lose or make money? Long position, bearish market, loses money. How much? The difference between when we open this contract, when we open this position, to when we are going to close. 60 cents is the difference. We have 500 contracts. Each contract is a thousand barrels. So we end up losing $300,000 here, and as we can see, the net is going to be negative $100,000. And again, as we can see, under this hedging strategy, we ended up losing some money. If there was no hedging, we could have made $200,000.

Credit: Farid Tayari

Now let's assume price increases considering two cases:

On November 1st, the cash prices are $60.35/bbl and the December futures contract would be $61.50/bbl.
On November 1,st the cash prices are $60.50/bbl and the December futures contract would be $61.40/bbl.

Example 11: On November 1st, the cash prices are $60.35/bbl and the December futures contract would be $61.50/bbl.

Example 11
Date	Cash Market	Financial Market	Net
Now	Short Price = $60/bbl	Long Refinery buys 500 December contracts Price = $61/bbl
November 1st	Price = $60.35/bbl Profit = (60-60.35)*500,000 = -$175,000	Close the position: Refinery sells 500 December contracts Price = $61.50/bbl Loss = (61.50-61)*500,000 = $250,000	-$175,000 + $250,000 = 75,000

Example 12: On November 1st, the cash prices are $60.50/bbl and the December futures contract would be $61.40/bbl.

Example 12
Date	Cash Market	Financial Market	Net
Now	Short Price = $60/bbl	Long Refinery buys 500 December contracts Price = $61/bbl
November 1st	Price = $60.50/bbl Profit = (60-60.50)*500,000 = -$250,000	Close the position: Refinery sells 500 December contracts Price = $61.40/bbl Loss = (61.40-61)*500,000 = $200,000	-$250,000 + $200,000 = -50,000

As we can see from the above examples, imperfect hedge doesn’t fully eliminate the price risks. In this case, hedging is still effective and gain or loss is much less than the case of not using the hedge.

Mini-lecture: Long hedge (buyer’s hedge), imperfect hedge example (4:53 minutes)

Long hedge (buyer’s hedge), imperfect hedge example, part 2 mini-lecture

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The next set of scenarios, which again involves this buyer, is a long hedge but the market is going to be bullish. Prices go up, right? Prices go up.

So, first example, we assume that it's early March. We will need crude oil for December. We work for a refinery. The cash market price right now is $60. The December futures are going to be $61. The market is going to be bullish, so prices go up in the cash market and in the futures, both 35 cents in the spot market but 50 cents in the futures. Let's calculate our loss and gain in each market and the net.

So, the hedging strategy is we have to take a long position in the financial market. This is the table. Prices go up. Do we make money or lose money in the cash market? So, our goal was $60. We are buyers. Prices go up, so we have to pay more. We have to pay 35 cents more, so we end up losing money in the cash market. How much? 35 cents times 500,000. We end up losing $175,000 in the cash market.

Futures. We took a long position. The market is bullish, right? Long position in a bullish market makes money. How much? The difference between prices when we open the position to when we are going to close it. 50 cents is the difference times 500 contracts times 1,000 barrels each. We end up making $250,000. The net is going to be $75,000.

So, under this hedging strategy, under this scenario, we not only didn't lose $175,000 in the cash market, we made some money. We made $75,000 as net under this hedging strategy.

Okay, the last example. The market is going to be bullish, but changes in the spot market are higher than the changes in the futures. So, the spot market increases by 50 cents, but futures increase by only 40 cents.

What happens? How much do we gain or lose in the cash and futures market? In the cash market, prices go up 50 cents. Do we make money or lose money? We are buyers. Prices go up, so we have to pay more. How much? 50 cents per barrel, and there are 500,000 barrels. We end up losing $250,000 in the cash market.

Do we make money or lose money in the financial market? Again, long position, bullish market, making money. How much? The difference between when we open the position to when we close it. 40 cents is the difference. 40 cents, 500 contracts, and 1,000 each, right? So, we are going to make $200,000 here. What is the net? Minus $250,000 plus $200,000. We are negative $50,000.

So, as you can see here, we still lost some money, but this money is far less compared to the $250,000 that we could have lost if we were not hedged, right? So, this is hedging using the financial futures contract hedging strategy.

Credit: Farid Tayari

More on Hedging

As we learned in the previous pages, gain and lose in hedging depends on the basis. Predicting the behavior of the basis could create an opportunity for making a profit. This is called arbitrage hedging. For example, from the concept of convergence, we can predict the basis to narrow over time. In a contango market, basis narrows with respect to the storage cost per time. However, in an inverted market, the basis narrows at the expiration date, but this rate is unpredictable.

In a contango market (carrying charges market) when basis narrows, short hedgers make a profit and long hedgers lose. And when basis widens, long hedgers make a profit and short hedgers lose.

In an inverted market (backwardation) when basis narrows, short hedgers lose and long hedgers make a profit. And when basis widens, long hedgers lose and short hedgers make a profit.

Note that in reality, many companies use different hedging techniques to not only reduce the risk but improve the profit.

Futures contracts exist for a limited number of commodities. However, existing futures contracts could also be used to hedge the price risk of relevant commodities that have no futures contract market. This is called cross-hedging.

Summary and Final Tasks

Key Learning Points: Lesson 7

The financial derivative contracts for energy commodities provide actual supply and market for commercial players.
Fixed prices for the commodities can be established as well.
Utilizing financial derivatives to reduce one’s price and supply/market risk is known as “hedging.”
Commercial entities must take a financial position that is the opposite of their physical position in order for the hedge transaction to be successful.
Producers of the commodity are said to be “long” the physical product and therefore, must be sellers in the financial market (sell contracts).
Consumers for the commodity are said to be “short” the physical product and, therefore, must be buyers in the financial market (buy the contracts).
Companies that lease storage capacity can hedge their price, supply, and market risk through buying contracts in one month and selling contracts in a subsequent month. This is known as a “time” or “storage” spread.
By taking these opposite positions, price changes in one market are offset by price changes in the other market. When these occur on a 1:1 basis, it is referred to as a “perfect” hedge.
These are known as “simple, fixed-price” hedges and represent the “first layer” of any more complex hedge transaction.

Over the past few weeks, you have been researching various Fundamental Factors that can be used to aid in making trading decisions. In the next two lessons, we will explore quantitative methods and price analysis.

Reminder - Complete all of the lesson tasks!

You have reached the end of this lesson. Double-check the list of requirements on the first page of this lesson to make sure you have completed all of the activities listed there before beginning the next lesson.