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.
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!
Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results....[Read on...]
If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount....[Read on...]
Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time.....[Read on...]
If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPSÂ® and why I consider them to be a great option for investing in the next MicrosoftÂ®.... [Read on...]
Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date....[Read on...]
As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative....[Read on...]
Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date....[Read on...]
To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin....[Read on...]
Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading.... [Read on...]
Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator.... [Read on...]
Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa.... [Read on...]
In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as "the greeks".... [Read on...]
Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow.... [Read on...]
Risk Warning: Stocks, futures and binary options trading discussed on this website can be considered High-Risk Trading Operations and their execution can be very risky and may result in significant losses or even in a total loss of all funds on your account. You should not risk more than you afford to lose. Before deciding to trade, you need to ensure that you understand the risks involved taking into account your investment objectives and level of experience. Information on this website is provided strictly for informational and educational purposes only and is not intended as a trading recommendation service. TheOptionsGuide.com shall not be liable for any errors, omissions, or delays in the content, or for any actions taken in reliance thereon.