Businesses that need to buy significant quantities of heating oil can hedge against rising heating oil price by taking up a position in the heating oil futures market.
These companies can employ what is known as a long hedge to secure a purchase price for a supply of heating oil that they will require sometime in the future.
To implement the long hedge, enough heating oil futures are to be purchased to cover the quantity of heating oil required by the business operator.
A heating oil distributor will need to procure 4.20 million gallons of heating oil in 3 months' time. The prevailing spot price for heating oil is USD 1.4777/gal while the price of heating oil futures for delivery in 3 months' time is USD 1.5000/gal. To hedge against a rise in heating oil price, the heating oil distributor decided to lock in a future purchase price of USD 1.5000/gal by taking a long position in an appropriate number of NYMEX Heating Oil futures contracts. With each NYMEX Heating Oil futures contract covering 42000 gallons of heating oil, the heating oil distributor 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 heating oil distributor will be able to purchase the 4.20 million gallons of heating oil at USD 1.5000/gal for a total amount of USD 6,300,000. Let's see how this is achieved by looking at scenarios in which the price of heating oil makes a significant move either upwards or downwards by delivery date.
With the increase in heating oil price to USD 1.6255/gal, the heating oil distributor will now have to pay USD 6,826,974 for the 4.20 million gallons of heating oil. However, the increased purchase price will be offset by the gains in the futures market.
By delivery date, the heating oil futures price will have converged with the heating oil spot price and will be equal to USD 1.6255/gal. As the long futures position was entered at a lower price of USD 1.5000/gal, it will have gained USD 1.6255 - USD 1.5000 = USD 0.1255 per gallon. With 100 contracts covering a total of 4.20 million gallons of heating oil, the total gain from the long futures position is USD 526,974.
In the end, the higher purchase price is offset by the gain in the heating oil futures market, resulting in a net payment amount of USD 6,826,974 - USD 526,974 = USD 6,300,000. This amount is equivalent to the amount payable when buying the 4.20 million gallons of heating oil at USD 1.5000/gal.
With the spot price having fallen to USD 1.3299/gal, the heating oil distributor will only need to pay USD 5,585,706 for the heating oil. However, the loss in the futures market will offset any savings made.
Again, by delivery date, the heating oil futures price will have converged with the heating oil spot price and will be equal to USD 1.3299/gal. As the long futures position was entered at USD 1.5000/gal, it will have lost USD 1.5000 - USD 1.3299 = USD 0.1701 per gallon. With 100 contracts covering a total of 4.20 million gallons, the total loss from the long futures position is USD 714,294
Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the heating oil futures market and the net amount payable will be USD 5,585,706 + USD 714,294 = USD 6,300,000. Once again, this amount is equivalent to buying 4.20 million gallons of heating oil at USD 1.5000/gal.
As you can see from the above examples, the downside of the long hedge is that the heating oil buyer would have been better off without the hedge if the price of the commodity fell.
An alternative way of hedging against rising heating oil prices while still be able to benefit from a fall in heating oil price is to buy heating oil call options.
To buy or sell futures, you need a broker that can handle futures trades.
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