Crude Oil producers can hedge against falling crude oil price by taking up a position in the crude oil futures market.
Crude Oil producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of crude oil that is only ready for sale sometime in the future.
To implement the short hedge, crude oil producers sell (short) enough crude oil futures contracts in the futures market to cover the quantity of crude oil to be produced.
An oil extraction company has just entered into a contract to sell 100,000 barrels of crude oil, to be delivered in 3 months' time. The sale price is agreed by both parties to be based on the market price of crude oil on the day of delivery. At the time of signing the agreement, 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 lock in the selling price at USD 44.00/barrel, the oil extraction company can enter a short position in an appropriate number of NYMEX Brent Crude Oil futures contracts. With each NYMEX Brent Crude Oil futures contract covering 1,000 barrels of crude oil, the oil extraction company will be required to short 100 futures contracts.
The effect of putting in place the hedge should guarantee that the oil extraction company will be able to sell 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.
As per the sales contract, the oil extraction company will have to sell the crude oil at only USD 39.78/barrel, resulting in a net sales proceeds of USD 3,978,000.
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 short futures position was entered at USD 44.00/barrel, it will have gained USD 44.00 - USD 39.78 = USD 4.2200 per barrel. With 100 contracts covering a total of 100000 barrels, the total gain from the short futures position is USD 422,000
Together, the gain in the crude oil futures market and the amount realised from the sales contract will total USD 422,000 + USD 3,978,000 = USD 4,400,000. This amount is equivalent to selling 100,000 barrels of crude oil at USD 44.00/barrel.
With the increase in crude oil price to USD 48.62/barrel, the crude oil producer will be able to sell the 100,000 barrels of crude oil for a higher net sales proceeds of USD 4,862,000.
However, as the short futures position was entered at a lower price of USD 44.00/barrel, it will have lost 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 loss from the short futures position is USD 462,000.
In the end, the higher sales proceeds is offset by the loss in the crude oil futures market, resulting in a net proceeds of USD 4,862,000 - USD 462,000 = USD 4,400,000. Again, this is the same amount that would be received by selling 100,000 barrels of crude oil at USD 44.00/barrel.
As can be seen from the above examples, the downside of the short hedge is that the crude oil seller would have been better off without the hedge if the price of the commodity went up.
An alternative way of hedging against falling crude oil prices while still be able to benefit from a rise in crude oil price is to buy crude oil put options.
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