Loading...

Welcome Back, {{ user.first_name }} {{ user.last_name }}!

Dashboard

Glossary

Bookmarks

My Account

Studies/News

The Basics of Hedging

Necessity for Hedging

The world oil markets have experienced dramatic volatility in recent years. Changing economic patterns, geopolitical turmoil, military conflict, weather as well as the nationalization of crude supplies by Middle Eastern producers, have sent oil prices on a treacherous path. Since 1997, spot month crude oil futures prices have moved erratically between $10.35 and $147.27. Some companies whose profitability was dependent upon the value of oil, turned to hedging to offset the risks associated with unpredictable prices. Many of those who declined this opportunity suffered the consequences.

Hedging: The Concept

For those unfamiliar with the term, hedging is simply the transfer of risk from a commercial interest (anyone who buys or sells physical product or a related financial type instrument) to a speculator or to another commercial interest with an opposite risk profile in the physical (cash) market. The central theory of hedging is that if the price of the actual commodity changes, either up or down, the price of the futures should change an equal amount. A hedge is established when a commercial interest assumes a position in the futures market that is equal in size, but opposite to their cash position. The purpose of this transaction is to establish a temporary substitute for a cash market transaction that will be made at a future date. (The paradox of hedging is that before risk can be minimized, additional risk must be undertaken. The key is that the second risk effectively negates the first.) Therefore, a loss in the cash market will be offset by an equivalent profit in the futures. This allows producers, refiners, retailers, and consumers to shift their focus away from unpredictable price changes that could have disastrous effects on the profitability of their company. Moreover, while hedging acts as price insurance to the end user, it also helps lock in profit margins for producers and retailers as well.

Basis

Even a cursory explanation of hedging would be difficult without discussing the term "basis". Simply stated, basis can be defined as the difference in price between cash and futures. It can be expressed numerically by subtracting the futures price from the cash price. Understanding this relationship is an integral part of the hedging process. Hedging would be far simpler if basis relationships always remained the same. Unfortunately, this is not the case. Sometimes futures prices change at a rate that do not exactly coincide with the cash market. Consequently, basis must be closely monitored. While basis risk can make some hedges imperfect, it can also create new opportunities for profit if managed correctly. Basis can be expressed either positively or negatively. The basis is negative, if cash is trading at a discount to futures. It would be regarded as positive if cash were at a premium to futures.

Long vs Short Hedges

Hedging can be approached from two sides -- as a long (buying) hedge, or as a short (selling) hedge. The determination of whether a hedger will sell futures or buy futures is dependent upon their position in the cash market. If a company has the physical fuel in inventory, they would sell (short) the futures in an effort to mitigate a potential loss in the value of that inventory. If they are in need of the physical fuel for delivery or eventual consumption, they would buy (long) the futures to protect themselves from rising prices. Remember, the position taken in the futures market is always opposite to the position in the cash market.

Practical Examples of Hedging

A strong candidate for a short futures hedge would be a producer, a party to a fixed priced contract, a refiner or a holder of physical inventory. One would advocate using this strategy when prices are perceived to be high, and the principal is concerned about protecting their interests in a declining market.

For example: On June 1st, the U.S. Gulf cash market is trading at $45.25 for Alaska North Slope. Acme Oil Company, a local refiner, decides to restock their crude inventory. At that time, August WTI crude futures are at $47.00. Acme sells an equal number of futures contracts at that price to protect themselves against a potential decline in the market. Since cash is below the price of futures, the basis is negative. This can be expressed as follows:

Date

Cash

Futures

Basis

June 1

$45.25

$47.00

-1.75

On June 15th, cash crude is trading at $42.75, and August futures are at $44.50. They decide to cover their short hedge and buy back the futures at a $2.50 profit.

Date

Cash

Futures

Basis

June 1

$45.25

$47.00

-1.75

June 15

$42.75

$44.50

-1.75

 

 In this theoretical example, the basis is unchanged. A loss in the cash was offset by a profit in the futures. Without the hedge in place, Acme would have suffered a $2.50 per barrel loss in the value of their inventory. 

The converse of the seller's short hedge would be a buyer's long hedge. This method would be used by a refiner buying crude oil for future needs, a marketer buying product for a fixed price sales contract, a trader with a deferred exchange obligation, or an end user. Their primary concern would be paying too much for their fuel needs.

For example: Prices are forecast to rise in the coming months. Blue Sky Airlines is considered to be short in the cash market because they have little or no storage capacity, and they burn the fuel as quickly as they buy it. Their risk management group decides to hedge their fuel needs for the next month by purchasing an equivalent number of contracts in the futures market. On May 1st, cash jet fuel is trading at $1.4000, while June futures are at $1.4200. They enter an order to buy futures at $1.4200, and the hedge is effective. Once again, the basis is negative.

Date

Cash

Futures

 Basis

May 1

$1.4000

$1.4200

-.0200

On May 25th, Blue Sky liquidates their long hedge by selling out their futures position. As predicted, prices have risen, but the increase in the airline's fuel cost was offset by the gain in their futures position.   

Date

Cash

Futures

 Basis

May 1

$1.4000

$1.4200

-.0200

May 25

$1.4400

$1.4600

-.0200


Hedging and Basis Risk

In both long and short examples, no basis change occurred. However, as stated earlier, basis relationships often fluctuate. These changes must be closely monitored, because they can have both favorable and unfavorable effects on the success of a hedging opportunity. The key to whether a hedge will be effective (a favorable basis swing), or ineffective (an unfavorable basis swing), depends on the initial basis when the hedge is placed, and the basis when the hedge is lifted. Moreover, it is the degree of change in the basis that is important, not the change in dollar value of cash or futures.

For example:

Date

Cash

Futures

Basis

May 1

$1.4000

$1.4200

 -.0200

May 25

$1.4400

$1.4700

  -.0300


In this circumstance, the trader benefited from a widening basis -- actually lowering Blue Sky's overall cost by .01 because their long futures position outperformed their loss in the cash market.

Unfortunately, the opposite is also possible ...

Date Cash Futures Basis
May 1 $ 1.4000 $ 1.4200 - .02
May 25 $ 1.4500 $ 1.4600 - .01

Here the basis narrowed with a large loss in cash outpacing the profit in futures. It is important to note however, that even in cases where an adverse fluctuation occurs, the airline would still benefit from hedging. Although Blue Sky lost .01 in the previous example, their loss would have been cents .05 if unhedged.

True Risk Management

Hedging is not a panacea. However, it can be an invaluable tool when managed properly. To be successful, you must first determine whether your particular risk is able to be hedged. Do the price trends for oil in your area mirror the prices on the NYMEX? Minimum 80% correlations are usually required for basis risk to be manageable. Complete basis and correlation studies should be completed before the feasibility of a program can be assessed. The Rafferty Commodities Group maintains one of the finest research departments in the industry. Our analysts can help you evaluate your position, and assist you in the development of a sound strategy. Admittedly, the cash market can sometimes provide better opportunities for risk management than futures or options. However, limiting a company's alternatives to the cash market alone can be a costly mistake. To be competitive in today's volatile environment, a broader view must be taken. Though some dismiss hedging as mere speculation, we believe those who ignore its potential are the ones who are truly speculating.

Back
Get Started Now!