When commercial parties enter the financial energy marketplace to reduce their supply and/or price risk, it is known as “hedging.” This is much the same as one who bets on the “favorite” in a horserace but “hedges” that bet by also placing bets on another possible winner. They hope to mitigate their losses should the favored horse not win.
In order to hedge supply and price risk correctly, physical players must take a financial position which is opposite to their physical position. For instance, a producer has a commodity and needs a market. (They are said to be “long” the commodity.) 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. (They are said to be “short” the commodity.) Therefore, they must 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 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?
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 5). (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, called "convergence", is covered in Errera.
Let's look at some simple examples of hedges for Producers and Consumers of natural gas.
Exxon-Mobil, the largest producer of natural gas in the US, wishes to sell some of its production for December, 2015 at the current market levels since those prices help them meet earnings targets. To hedge 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. And, they can do this for any months 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 "spread" between 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, 2015 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.