Coal producers can hedge against falling coal price by taking up a position in the coal futures market.
Coal producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of coal that is only ready for sale sometime in the future.
To implement the short hedge, coal producers sell (short) enough coal futures contracts in the futures market to cover the quantity of coal to be produced.
A coal mining firm has just entered into a contract to sell 155,000 tons of coal, to be delivered in 3 months' time. The sale price is agreed by both parties to be based on the market price of coal on the day of delivery. At the time of signing the agreement, spot price for coal is USD 74.45/ton while the price of coal futures for delivery in 3 months' time is USD 74.00/ton.
To lock in the selling price at USD 74.00/ton, the coal mining firm can enter a short position in an appropriate number of NYMEX Coal futures contracts. With each NYMEX Coal futures contract covering 1,550 tons of coal, the coal mining firm will be required to short 100 futures contracts.
The effect of putting in place the hedge should guarantee that the coal mining firm will be able to sell the 155,000 tons of coal at USD 74.00/ton for a total amount of USD 11,470,000. Let's see how this is achieved by looking at scenarios in which the price of coal makes a significant move either upwards or downwards by delivery date.
As per the sales contract, the coal mining firm will have to sell the coal at only USD 67.01/ton, resulting in a net sales proceeds of USD 10,385,775.
By delivery date, the coal futures price will have converged with the coal spot price and will be equal to USD 67.01/ton. As the short futures position was entered at USD 74.00/ton, it will have gained USD 74.00 - USD 67.01 = USD 6.9950 per ton. With 100 contracts covering a total of 155000 tons, the total gain from the short futures position is USD 1,084,225
Together, the gain in the coal futures market and the amount realised from the sales contract will total USD 1,084,225 + USD 10,385,775 = USD 11,470,000. This amount is equivalent to selling 155,000 tons of coal at USD 74.00/ton.
With the increase in coal price to USD 81.90/ton, the coal producer will be able to sell the 155,000 tons of coal for a higher net sales proceeds of USD 12,693,725.
However, as the short futures position was entered at a lower price of USD 74.00/ton, it will have lost USD 81.90 - USD 74.00 = USD 7.8950 per ton. With 100 contracts covering a total of 155,000 tons of coal, the total loss from the short futures position is USD 1,223,725.
In the end, the higher sales proceeds is offset by the loss in the coal futures market, resulting in a net proceeds of USD 12,693,725 - USD 1,223,725 = USD 11,470,000. Again, this is the same amount that would be received by selling 155,000 tons of coal at USD 74.00/ton.
As can be seen from the above examples, the downside of the short hedge is that the coal seller would have been better off without the hedge if the price of the commodity went up.
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