Businesses that need to buy significant quantities of crude oil can hedge against rising crude oil price by taking up a position in the crude oil futures market.
These companies can employ what is known as a long hedge to secure a purchase price for a supply of crude oil that they will require sometime in the future.
To implement the long hedge, enough crude oil futures are to be purchased to cover the quantity of crude oil required by the business operator.
An oil refinery will need to procure 100,000 barrels of crude oil in 3 months' time. The prevailing spot price for crude oil is USD 44.20/barrel while the price of crude oil futures for delivery in 3 months' time is USD 44.00/barrel. To hedge against a rise in crude oil price, the oil refinery decided to lock in a future purchase price of USD 44.00/barrel by taking a long position in an appropriate number of NYMEX Brent Crude Oil futures contracts. With each NYMEX Brent Crude Oil futures contract covering 1000 barrels of crude oil, the oil refinery will be required to go long 100 futures contracts to implement the hedge.
The effect of putting in place the hedge should guarantee that the oil refinery will be able to purchase the 100,000 barrels of crude oil at USD 44.00/barrel for a total amount of USD 4,400,000. Let's see how this is achieved by looking at scenarios in which the price of crude oil makes a significant move either upwards or downwards by delivery date.
With the increase in crude oil price to USD 48.62/barrel, the oil refinery will now have to pay USD 4,862,000 for the 100,000 barrels of crude oil. However, the increased purchase price will be offset by the gains in the futures market.
By delivery date, the crude oil futures price will have converged with the crude oil spot price and will be equal to USD 48.62/barrel. As the long futures position was entered at a lower price of USD 44.00/barrel, it will have gained USD 48.62 - USD 44.00 = USD 4.6200 per barrel. With 100 contracts covering a total of 100,000 barrels of crude oil, the total gain from the long futures position is USD 462,000.
In the end, the higher purchase price is offset by the gain in the crude oil futures market, resulting in a net payment amount of USD 4,862,000 - USD 462,000 = USD 4,400,000. This amount is equivalent to the amount payable when buying the 100,000 barrels of crude oil at USD 44.00/barrel.
With the spot price having fallen to USD 39.78/barrel, the oil refinery will only need to pay USD 3,978,000 for the crude oil. However, the loss in the futures market will offset any savings made.
Again, by delivery date, the crude oil futures price will have converged with the crude oil spot price and will be equal to USD 39.78/barrel. As the long futures position was entered at USD 44.00/barrel, it will have lost USD 44.00 - USD 39.78 = USD 4.2200 per barrel. With 100 contracts covering a total of 100,000 barrels, the total loss from the long futures position is USD 422,000
Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the crude oil futures market and the net amount payable will be USD 3,978,000 + USD 422,000 = USD 4,400,000. Once again, this amount is equivalent to buying 100,000 barrels of crude oil at USD 44.00/barrel.
As you can see from the above examples, the downside of the long hedge is that the crude oil buyer would have been better off without the hedge if the price of the commodity fell.
An alternative way of hedging against rising crude oil prices while still be able to benefit from a fall in crude oil price is to buy crude oil call options.
To buy or sell futures, you need a broker that can handle futures trades.
OptionsHouse is a full fledged Futures Commission Merchant that provides a streamlined access to the futures markets at extremely reasonable contract rates.Click here to open a futures trading account at OptionsHouse.com now!
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