Overview

We've learned that NYMEX energy contracts represent the actual right to buy or sell energy commodities. So, for the commercial market participants, these provide both a market for production and a source of supply. For instance, producers of natural gas, crude oil, or refined products such as heating oil and gasoline, can sell financial contracts, thus guaranteeing that they will have a firm market in the future at a fixed price. Conversely, consumers of these same products can buy contracts to ensure that they will have a firm supply source in the future at a set price. Utilizing financial contracts to reduce price and/or commodity risk is known as "hedging." In this lesson, we will discover the ways in which commercial players in the energy industry use the financial markets for hedging their risks.

Key Learning Points – Energy Risk Hedging

• Producers and consumers of energy can reduce both their physical (market or supply) and price risk using financial derivatives such as futures and forwards.
• Futures are exchange-traded contracts such as the NYMEX energy commodities: crude, natural gas, heating oil and unleaded gasoline.
• “Over-the-counter,” or “OTC” contracts, are known as “forwards.” These are non-exchange traded and can either involve an electronic trading platform or “voice” broker.
• Hedgers are not speculators.
• In a hedge, commercial participants in financial markets take the opposite position from what they have in the physical markets.
• Financial positions must be settled monthly.
• Storage capacity can be hedged through buying one month and selling a future month.

Learning Outcomes

At the successful completion of this lesson, students should be able to:

• explain how price risk reduction can occur through the use of basic financial derivatives like NYMEX contracts and “basis swaps”;
• describe how commodity risk can be reduced;
• demonstrate a simple “hedge” structure for:
  • energy commodity producers;
  • energy commodity consumers;
  • storage.

What is due for this lesson?

This lesson will take us one week to complete. The following items will be due Sunday at 11:59 p.m. Eastern Time. 

• Lesson 7 Quiz
• Lesson 7 activities as assigned in Canvas

Questions?

If you have any questions, please post them to our General Course Questions discussion forum (not email), located under Modules in Canvas. The TA and I will check that discussion forum daily to respond. While you are there, feel free to post your own responses if you, too, are able to help out a classmate.

In Lesson 3, we defined an energy futures contract and the function of the NYMEX. We also identified the two main participants in financial energy markets as “commercial” and “non-commercial” players.

Commercial entities have an interest in the commodity itself due to the particular business they are in. For example, an oil refinery not only needs actual crude oil but also has a stake in the future price of oil. This is the basic feedstock for all of the refined products they produce and, therefore, their profitability is impacted by the purchase price of crude.

In addition, refiners sell products such as gasoline and heating oil, both of which are traded in the financial markets. So, the refiner’s profit is also dependent on the feedstock price for crude and the market price for what it produces.

On the other hand, exploration and production companies need to know the future market price of the crude oil they will extract from their wells.

The same holds true for natural gas. In some cases, natural gas is a component of manufacturing costs in such industries as fertilizers and food processing. In the power industry, the price of natural gas impacts the cost of generating electricity. And for midstream processors, natural gas is the main component for the extraction of valuable natural gas liquids (NGLs).

E&P companies that produce natural gas can also see the future market prices for their production.

Keeping in mind that futures contracts are legally binding obligations to buy or sell a commodity, they guarantee a market for producers and a source of supply for consumers. They also guarantee a set or “fixed” price, thereby reducing price risk as well.

In Lesson 4, we learned about the spot market (it is also called the physical market, or the cash market), as the market where the actual physical commodity is traded. Local spot market price is determined by the local supply and local demand, and it can become very volatile because local supply has to be planned by the producers in advance and producers don’t know the exact demand ahead of time. The difference between financial and physical market prices is called basis. 

The effectiveness of hedging is highly dependent on the relationship between futures and spot market prices. This relationship can be explained by parallelism and convergence. 

Parallelism represents the close relationship between futures and spot market prices, and the fact that both are influenced by similar factors. Parallelism explains the fact that futures and spot market prices track each other (they are highly correlated). The fact that futures contract price tends to get very close to the cash market price is called convergence. 

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.

Exxon-Mobil, 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)

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.

Perfect Hedge

1. Seller's hedge or short hedge 

Assume the current spot market price for crude oil is $60/bbl. A crude oil producer is planning to sell 500,000 barrels of crude oil in the cash market in December (they are said to be “long” the commodity). As we learned in Lesson 4, commodity prices in the spot market (cash or physical market) are affected by the local supply and demand. Consequently, spot market prices are more volatile than the futures prices and the producer is subject to price risk until December. 

Assume the current NYMEX December futures market price is $61.00. In order to hedge the December price against the price fluctuations, the crude oil producer has to take the short position (the opposite of the physical position) in the financial market and sell 500 December crude oil contracts. When the hedger has the long position in the spot market and the short position in the financial market, it is called seller's hedge or short hedge. In this case, the price is now set at $61.00 for December delivery of West Texas Intermediate Crude Oil at the Cushing, OK, Hub.

However, the crude oil producer is intending to sell the product in the spot market and not interested in delivering the crude oil at the Cushing, OK, Hub. And remember that all December futures contracts must be financially settled at the end of November according to the rules of the exchange. So, by the end of November, the producer must buy back the contracts in order to balance their financial position (close the position). Remember, if producer doesn't close the financial position, they have to deliver the crude oil to Cushing, OK, Hub.

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. 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 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. If the spot and financial markets move exactly in tandem, this results in a perfect hedge. We refer to a “perfect” hedge when there is a 1:1 correlation between the financial and physical markets. 

Example 1: Assume the price has gone down. On November 1st the spot market prices are $59.3/bbl and in that case (assuming perfect hedge) the December futures contract would be $60.30/bbl.

In this case, the loss in the spot market is offset by the profit in the financial market.

Example 2: Assume the price increased and on November 1st the cash prices are $60.50/bbl. In that case (assuming perfect hedge) the December futures contract would be $61.50/bbl.

As we can see in the above table, the profit in the spot market is offset by the loss in the financial market.

Mini-lecture: Short hedge (seller’s hedge) (10:51 minutes)

2. Buyer's hedge or long hedge 

Assume a refinery is planning to buy the same amount of crude oil in the same spot market and the refinery wants to hedge the December price and its profit against the price fluctuations. The refinery is said to be “short” the commodity and having the short position in the spot market. In order to hedge, the refinery has to buy 500 December futures contracts (1000 bbl each) in the financial market and sell them by the end of November (closing position). This is called buyer's hedge or long hedge, which is opposite to the seller's hedge.

Example 3: Assume on November 1st, the spot market prices are $59.3/bbl and in that case (assuming perfect hedge) the December futures contract would be $60.30/bbl.

The profit in the spot market is offset by the loss in the financial market.

Example 4: Assume prices increased and on November 1st the cash prices are $60.50/bbl and in that case (assuming perfect hedge) the December futures contract would be $61.50/bbl.

As we can see in the above table, the refinery's loss in the spot market is offset by the profit in the financial market.

Note that based on the concept of "convergence", getting close to the expiration date, the final settlement price for the December crude oil contract on the NYMEX would represent the cash market price for that month.

This process can be performed many times over by the producers and consumers as desired. Thus, suppliers and end-users can establish a fixed-price and hedge against the price fluctuations. 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).

Mini-lecture: Long hedge (buyer’s hedge) (5:23 minutes)

As we learned previously, the perfect hedge can remove the price risks for sellers and buyers in the spot market. In the perfect hedge, we assume spot and financial market move exactly in tandem and prices in both markets are perfectly correlated, which means the case basis (the difference between spot and futures prices) stays unchanged. However, this assumption is not very realistic. Spot and futures market prices are highly correlated (parallelism) but the correlation is not usually perfect and basis changes over time. In that case, hedging is still effective, but it doesn’t eliminate the price risk. The hedger’s gain and loss in the spot and futures market are not fully offset, and the hedger will end up with some gain or loss. This is called imperfect hedge. Note that the gain or loss of hedging will be much less than not utilizing hedge.

1. Seller's hedge or short hedge

Following the example from the previous page, assume the price has gone down between the time of selling the futures contract and November 1st and the basis has changed a bit (imperfect hedge). Let's explore two cases:

• On November 1st, the spot market prices are $59.5/bbl and the December futures contract would be $60.60/bbl.
• On November 1st, the spot market prices are $59.60/bbl and the December futures contract would be $60.40/bbl.

Example 5: On November 1st, the spot market prices are $59.50/bbl and the December futures contract would be $60.60/bbl.

Example 6: November 1st the spot market prices are $59.60/bbl and the December futures contract would be $60.40/bbl:

As the results show, gain or loss in the spot market are not fully offset by the loss or gain in the financial market. But hedging is still effective in reducing the risk.

Now, let's assume the price goes up from the time of selling the futures contracts in NYMEX to November. We consider two cases:

Mini-lecture: Short hedge (seller’s hedge) imperfect hedge example (8:08 minutes)

• On November 1st, the cash prices are $60.35/bbl and the December futures contract would be $61.50/bbl.
• On November 1st, the cash prices are $60.50/bbl and the December futures contract would be $61.40/bbl.

Example 7: November 1st, the cash prices are $60.35/bbl and the December futures contract would be $61.50/bbl.

Example 8: November 1st the cash prices are $60.50/bbl and the December futures contract would be $61.40/bbl.

Mini-lecture: Short hedge (seller’s hedge), imperfect hedge example (5:00 minutes)

2. Buyer's hedge or long hedge

Following the example from the previous page, assume prices have gone down from the time the refinery buys the future contracts until November 1st. Let's consider the above cases:

• On November 1st, the spot market prices are $59.50/bbl and the December futures contract would be $60.60/bbl.
• On November 1st, the spot market prices are $59.60/bbl and the December futures contract would be $60.40/bbl.

Example 9: On November 1st, the spot market prices are $59.50/bbl and the December futures contract would be $60.60/bbl.

Example 10: On November 1st, the spot market prices are $59.60/bbl and the December future contract would be $60.40/bbl.

Mini-lecture: Long hedge (buyer’s hedge), imperfect hedge example (6:32 minutes)

Now let's assume price increases considering two cases:

• On November 1st, the cash prices are $60.35/bbl and the December futures contract would be $61.50/bbl.
• On November 1,st the cash prices are $60.50/bbl and the December futures contract would be $61.40/bbl.

Example 11: On November 1st, the cash prices are $60.35/bbl and the December futures contract would be $61.50/bbl.

Example 12: On November 1st, the cash prices are $60.50/bbl and the December futures contract would be $61.40/bbl.

As we can see from the above examples, imperfect hedge doesn’t fully eliminate the price risks. In this case, hedging is still effective and gain or loss is much less than the case of not using the hedge.

Mini-lecture: Long hedge (buyer’s hedge), imperfect hedge example (4:53 minutes)

As we learned in the previous pages, gain and lose in hedging depends on the basis. Predicting the behavior of the basis could create an opportunity for making a 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, the basis narrows at the expiration date, but this rate is unpredictable.   

In a contango market (carrying charges market) when basis narrows, short hedgers make a profit and long hedgers lose. And when basis widens, long hedgers make a profit and short hedgers lose.

In an inverted market (backwardation) when basis narrows, short hedgers lose and long hedgers make a profit. And when basis widens, long hedgers lose and short hedgers make a profit.

Note that in reality, many companies use different hedging techniques to not only reduce the risk but improve the profit.

Futures contracts exist for a limited number of commodities. However, existing futures contracts could also be used to hedge the price risk of relevant commodities that have no futures contract market. This is called cross-hedging.

Key Learning Points: Lesson 7

1. The financial derivative contracts for energy commodities provide actual supply and market for commercial players.
2. Fixed prices for the commodities can be established as well.
3. Utilizing financial derivatives to reduce one’s price and supply/market risk is known as “hedging.”
4. Commercial entities must take a financial position that is the opposite of their physical position in order for the hedge transaction to be successful.
5. Producers of the commodity are said to be “long” the physical product and therefore, must be sellers in the financial market (sell contracts).
6. Consumers for the commodity are said to be “short” the physical product and, therefore, must be buyers in the financial market (buy the contracts).
7. Companies that lease storage capacity can hedge their price, supply, and market risk through buying contracts in one month and selling contracts in a subsequent month. This is known as a “time” or “storage” spread.
8. By taking these opposite positions, price changes in one market are offset by price changes in the other market. When these occur on a 1:1 basis, it is referred to as a “perfect” hedge.
9. These are known as “simple, fixed-price” hedges and represent the “first layer” of any more complex hedge transaction.

Over the past few weeks, you have been researching various Fundamental Factors that can be used to aid in making trading decisions. In the next two lessons, we will explore quantitative methods and price analysis. 

Reminder - Complete all of the lesson tasks!

You have reached the end of this lesson. Double-check the list of requirements on the first page of this lesson to make sure you have completed all of the activities listed there before beginning the next lesson.