Gasoline producers can hedge against falling gasoline price by taking up a position in the gasoline futures market.
Gasoline producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of gasoline that is only ready for sale sometime in the future.
To implement the short hedge, gasoline producers sell (short) enough gasoline futures contracts in the futures market to cover the quantity of gasoline to be produced.
An oil refinery has just entered into a contract to sell 5,000 kiloliters of gasoline, to be delivered in 3 months' time. The sale price is agreed by both parties to be based on the market price of gasoline on the day of delivery. At the time of signing the agreement, spot price for gasoline is JPY 31,820/kl while the price of gasoline futures for delivery in 3 months' time is JPY 32,000/kl.
To lock in the selling price at JPY 32,000/kl, the oil refinery can enter a short position in an appropriate number of TOCOM Gasoline futures contracts. With each TOCOM Gasoline futures contract covering 50 kiloliters of gasoline, the oil refinery will be required to short 100 futures contracts.
The effect of putting in place the hedge should guarantee that the oil refinery will be able to sell the 5,000 kiloliters of gasoline at JPY 32,000/kl for a total amount of JPY 160,000,000. Let's see how this is achieved by looking at scenarios in which the price of gasoline makes a significant move either upwards or downwards by delivery date.
As per the sales contract, the oil refinery will have to sell the gasoline at only JPY 28,638/kl, resulting in a net sales proceeds of JPY 143,190,000.
By delivery date, the gasoline futures price will have converged with the gasoline spot price and will be equal to JPY 28,638/kl. As the short futures position was entered at JPY 32,000/kl, it will have gained JPY 32,000 - JPY 28,638 = JPY 3,362 per kiloliter. With 100 contracts covering a total of 5000 kiloliters, the total gain from the short futures position is JPY 16,810,000
Together, the gain in the gasoline futures market and the amount realised from the sales contract will total JPY 16,810,000 + JPY 143,190,000 = JPY 160,000,000. This amount is equivalent to selling 5,000 kiloliters of gasoline at JPY 32,000/kl.
With the increase in gasoline price to JPY 35,002/kl, the gasoline producer will be able to sell the 5,000 kiloliters of gasoline for a higher net sales proceeds of JPY 175,010,000.
However, as the short futures position was entered at a lower price of JPY 32,000/kl, it will have lost JPY 35,002 - JPY 32,000 = JPY 3,002 per kiloliter. With 100 contracts covering a total of 5,000 kiloliters of gasoline, the total loss from the short futures position is JPY 15,010,000.
In the end, the higher sales proceeds is offset by the loss in the gasoline futures market, resulting in a net proceeds of JPY 175,010,000 - JPY 15,010,000 = JPY 160,000,000. Again, this is the same amount that would be received by selling 5,000 kiloliters of gasoline at JPY 32,000/kl.
As can be seen from the above examples, the downside of the short hedge is that the gasoline seller would have been better off without the hedge if the price of the commodity went up.
An alternative way of hedging against falling gasoline prices while still be able to benefit from a rise in gasoline price is to buy gasoline put options.
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