Now, let’s take this line of thinking one step further and examine the steps in an actual financial energy hedge.
A crude oil Producer wishes to hedge its December, 2015 price. The current futures market price is $45.00 based on NYMEX trading. The Producer decides to sell December, 2015 crude oil contracts (the opposite of the physical position). Their price is now set at $45.00 for the sale of December, 2015, West Texas Intermediate Crude Oil at the Cushing, OK, Hub.
However, at the end of Novembe 2015, all December futures contracts must be financially settled according to the rules of the Exchange. So, the Producer must now buy back the contracts in order to balance their financial position.
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. Based on the concept of "convergence" (Errera), the Final Settlement price for the December, 2015 crude oil contract on the NYMEX would represent the cash market price for that month.
That means that 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 2015 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. We refer to this as a “perfect” hedge where there is a 1:1 correlation between the financial and physical markets.
This spreadsheet illustrates how this is calculated in a rising and falling financial market.
(Spreadsheet can be found in the Canvas Modules under Lesson 8: Basic Energy Risk “Hedging” using Financial Derivatives. "Lesson 8 simple hedge worksheet.xls")
This process can be performed many times over by Producer and Consumer as desired. Thus, suppliers and end-users can establish a fixed-price and ensure themselves a market or supply for energy commodities that are financially traded. 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).
Keep in mind that, for the purposes of this lesson, the energy commodities are being physically delivered at their respective contract points. We will address how to figure pricing for locations other than the financial “hubs” in a later lesson.
If one wishes to enter into a contract for underground storage capacity, this transaction can be hedged as well.
Let’s look at an example. The April 2016 NYMEX natural gas contract is trading $2.40 at the time of this writing. We can buy these contracts and that will represent the supply that we would inject into storage in April, 2016. Now, we need a market for when we wish to withdraw these same volumes. January, 2017 is trading at $2.95, so we would sell the January, 2017 futures contracts in the same amount as we bought in April, 2016. This creates a “spread” of $0.55. After the respective monthly storage fees are taken-out, we are left with the “net” spread on our storage transaction. This is also known as a “time spread” since it involves a purchase and sale of the same commodity in differing months.
(Spreadsheet can be found in the Canvas Modules under Lesson 8: Basic Energy Risk “Hedging” using Financial Derivatives.. "EBF-301 Lesson 8 simple hedge worksheet.xls")
These simple, “fixed-price” hedges are the basic building blocks for more complex financial derivative hedges.