Hedging Against Rising Crude Oil Prices using Crude Oil Futures

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Contents

Hedging Against Rising Crude Oil Prices using Crude Oil Futures

Businesses that need to buy significant quantities of crude oil can hedge against rising crude oil price by taking up a position in the crude oil futures market.

These companies can employ what is known as a long hedge to secure a purchase price for a supply of crude oil that they will require sometime in the future.

To implement the long hedge, enough crude oil futures are to be purchased to cover the quantity of crude oil required by the business operator.

Crude Oil Futures Long Hedge Example

An oil refinery will need to procure 100,000 barrels of crude oil in 3 months’ time. The prevailing spot price for crude oil is USD 44.20/barrel while the price of crude oil futures for delivery in 3 months’ time is USD 44.00/barrel. To hedge against a rise in crude oil price, the oil refinery decided to lock in a future purchase price of USD 44.00/barrel by taking a long position in an appropriate number of NYMEX Brent Crude Oil futures contracts. With each NYMEX Brent Crude Oil futures contract covering 1000 barrels of crude oil, the oil refinery will be required to go long 100 futures contracts to implement the hedge.

The effect of putting in place the hedge should guarantee that the oil refinery will be able to purchase the 100,000 barrels of crude oil at USD 44.00/barrel for a total amount of USD 4,400,000. Let’s see how this is achieved by looking at scenarios in which the price of crude oil makes a significant move either upwards or downwards by delivery date.

Scenario #1: Crude Oil Spot Price Rose by 10% to USD 48.62/barrel on Delivery Date

With the increase in crude oil price to USD 48.62/barrel, the oil refinery will now have to pay USD 4,862,000 for the 100,000 barrels of crude oil. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the crude oil futures price will have converged with the crude oil spot price and will be equal to USD 48.62/barrel. As the long futures position was entered at a lower price of USD 44.00/barrel, it will have gained USD 48.62 – USD 44.00 = USD 4.6200 per barrel. With 100 contracts covering a total of 100,000 barrels of crude oil, the total gain from the long futures position is USD 462,000.

In the end, the higher purchase price is offset by the gain in the crude oil futures market, resulting in a net payment amount of USD 4,862,000 – USD 462,000 = USD 4,400,000. This amount is equivalent to the amount payable when buying the 100,000 barrels of crude oil at USD 44.00/barrel.

Scenario #2: Crude Oil Spot Price Fell by 10% to USD 39.78/barrel on Delivery Date

With the spot price having fallen to USD 39.78/barrel, the oil refinery will only need to pay USD 3,978,000 for the crude oil. However, the loss in the futures market will offset any savings made.

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Again, by delivery date, the crude oil futures price will have converged with the crude oil spot price and will be equal to USD 39.78/barrel. As the long futures position was entered at USD 44.00/barrel, it will have lost USD 44.00 – USD 39.78 = USD 4.2200 per barrel. With 100 contracts covering a total of 100,000 barrels, the total loss from the long futures position is USD 422,000

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the crude oil futures market and the net amount payable will be USD 3,978,000 + USD 422,000 = USD 4,400,000. Once again, this amount is equivalent to buying 100,000 barrels of crude oil at USD 44.00/barrel.

Risk/Reward Tradeoff

As you can see from the above examples, the downside of the long hedge is that the crude oil buyer would have been better off without the hedge if the price of the commodity fell.

An alternative way of hedging against rising crude oil prices while still be able to benefit from a fall in crude oil price is to buy crude oil call options.

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Hedging Against Falling Crude Oil Prices using Crude Oil Futures

Crude Oil producers can hedge against falling crude oil price by taking up a position in the crude oil futures market.

Crude Oil producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of crude oil that is only ready for sale sometime in the future.

To implement the short hedge, crude oil producers sell (short) enough crude oil futures contracts in the futures market to cover the quantity of crude oil to be produced.

Crude Oil Futures Short Hedge Example

An oil extraction company has just entered into a contract to sell 100,000 barrels of crude oil, to be delivered in 3 months’ time. The sale price is agreed by both parties to be based on the market price of crude oil on the day of delivery. At the time of signing the agreement, spot price for crude oil is USD 44.20/barrel while the price of crude oil futures for delivery in 3 months’ time is USD 44.00/barrel.

To lock in the selling price at USD 44.00/barrel, the oil extraction company can enter a short position in an appropriate number of NYMEX Brent Crude Oil futures contracts. With each NYMEX Brent Crude Oil futures contract covering 1,000 barrels of crude oil, the oil extraction company will be required to short 100 futures contracts.

The effect of putting in place the hedge should guarantee that the oil extraction company will be able to sell the 100,000 barrels of crude oil at USD 44.00/barrel for a total amount of USD 4,400,000. Let’s see how this is achieved by looking at scenarios in which the price of crude oil makes a significant move either upwards or downwards by delivery date.

Scenario #1: Crude Oil Spot Price Fell by 10% to USD 39.78/barrel on Delivery Date

As per the sales contract, the oil extraction company will have to sell the crude oil at only USD 39.78/barrel, resulting in a net sales proceeds of USD 3,978,000.

By delivery date, the crude oil futures price will have converged with the crude oil spot price and will be equal to USD 39.78/barrel. As the short futures position was entered at USD 44.00/barrel, it will have gained USD 44.00 – USD 39.78 = USD 4.2200 per barrel. With 100 contracts covering a total of 100000 barrels, the total gain from the short futures position is USD 422,000

Together, the gain in the crude oil futures market and the amount realised from the sales contract will total USD 422,000 + USD 3,978,000 = USD 4,400,000. This amount is equivalent to selling 100,000 barrels of crude oil at USD 44.00/barrel.

Scenario #2: Crude Oil Spot Price Rose by 10% to USD 48.62/barrel on Delivery Date

With the increase in crude oil price to USD 48.62/barrel, the crude oil producer will be able to sell the 100,000 barrels of crude oil for a higher net sales proceeds of USD 4,862,000.

However, as the short futures position was entered at a lower price of USD 44.00/barrel, it will have lost USD 48.62 – USD 44.00 = USD 4.6200 per barrel. With 100 contracts covering a total of 100,000 barrels of crude oil, the total loss from the short futures position is USD 462,000.

In the end, the higher sales proceeds is offset by the loss in the crude oil futures market, resulting in a net proceeds of USD 4,862,000 – USD 462,000 = USD 4,400,000. Again, this is the same amount that would be received by selling 100,000 barrels of crude oil at USD 44.00/barrel.

Risk/Reward Tradeoff

As can be seen from the above examples, the downside of the short hedge is that the crude oil seller would have been better off without the hedge if the price of the commodity went up.

An alternative way of hedging against falling crude oil prices while still be able to benefit from a rise in crude oil price is to buy crude oil put options.

Learn More About Crude Oil Futures & Options Trading

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Continue Reading.

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

4 Ways Airlines Hedge Against Oil

The largest operating cost center for airlines, on average, are the companies’ fuel expenses and those expenses related to the procurement of oil.

When oil prices are increasing in the global economy, it’s natural that the stock prices of airlines drop. When oil prices decline in the economy, it’s equally natural that the stock prices of airlines go up. Fuel costs are such a large part of an airline’s overhead percentage-wise that the fluctuating price of oil greatly affects the airline’s bottom line.

To protect themselves from volatile oil costs, and sometimes to even take advantage of the situation, airlines commonly practice fuel hedging. They do this by buying or selling the expected future price of oil through a range of investment products, protecting the airline companies against rising prices.

Purchasing Current Oil Contracts

In this hedging scenario, an airline would have to believe that prices will rise in the future. To mitigate these rising prices, the airline purchases large amounts of current oil contracts for its future needs.

This is similar to a person who knows that the price of gas will increase over the next 12 months and that he will need 100 gallons of gas for his car over the next 12 months. Instead of buying gas as needed, he decides to purchase all 100 gallons at the current price, which he expects to be lower than the gas prices in the future.

Purchasing Call Options

When a company purchases a call option, it allows the company to purchase a stock or commodity at a specific price within a certain date range. This means that airline companies are able to hedge against rising fuel prices by buying the right to purchase oil in the future at a price that is agreed on today.

For example, if the current price per barrel is $100, but an airline company believes that the prices will increase, that airline company can purchase a call option for $5 that gives it the right to purchase a barrel of oil for $110 within a 120-day period. If the price per barrel of oil increases to above $115 within 120 days, the airline will end up saving money.

Implementing a Collar Hedge

Similar to a call option strategy, airlines can also implement a collar hedge, which requires a company to purchase both a call option and a put option. Where a call option allows an investor to purchase a stock or commodity at a future date for a price that’s agreed upon today, a put option allows an investor to do the opposite: sell a stock or commodity at a future date for a price that’s agreed on today.

A collar hedge uses a put option to protect an airline from a decline in the price of oil if that airline expects oil prices to increase. In the example above, if fuel prices increase, the airline would lose $5 per call option contract. A collar hedge protects the airline against this loss.

Purchasing Swap Contracts

Finally, an airline can implement a swap strategy to hedge against the potential of rising fuel costs. A swap is similar to a call option, but with more stringent guidelines. While a call option gives an airline the right to purchase oil in the future at a certain price, it doesn’t require the company to do so.

A swap, on the other hand, locks in the purchase of oil at a future price at a specified date. If fuel prices decline instead, the airline company has the potential to lose much more than it would with a call option strategy.

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