PrintCommercial 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)
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.