Heating Oil producers can hedge against falling heating oil price by taking up a position in the heating oil futures market.
Heating Oil producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of heating oil that is only ready for sale sometime in the future.
To implement the short hedge, heating oil producers sell (short) enough heating oil futures contracts in the futures market to cover the quantity of heating oil to be produced.
An oil refinery has just entered into a contract to sell 4.20 million gallons of heating oil, to be delivered in 3 months' time. The sale price is agreed by both parties to be based on the market price of heating oil on the day of delivery. At the time of signing the agreement, 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 lock in the selling price at USD 1.5000/gal, the oil refinery can enter a short position in an appropriate number of NYMEX Heating Oil futures contracts. With each NYMEX Heating Oil futures contract covering 42,000 gallons of heating oil, 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 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.
As per the sales contract, the oil refinery will have to sell the heating oil at only USD 1.3299/gal, resulting in a net sales proceeds of USD 5,585,706.
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 short futures position was entered at USD 1.5000/gal, it will have gained USD 1.5000 - USD 1.3299 = USD 0.1701 per gallon. With 100 contracts covering a total of 4200000 gallons, the total gain from the short futures position is USD 714,294
Together, the gain in the heating oil futures market and the amount realised from the sales contract will total USD 714,294 + USD 5,585,706 = USD 6,300,000. This amount is equivalent to selling 4.20 million gallons of heating oil at USD 1.5000/gal.
With the increase in heating oil price to USD 1.6255/gal, the heating oil producer will be able to sell the 4.20 million gallons of heating oil for a higher net sales proceeds of USD 6,826,974.
However, as the short futures position was entered at a lower price of USD 1.5000/gal, it will have lost 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 loss from the short futures position is USD 526,974.
In the end, the higher sales proceeds is offset by the loss in the heating oil futures market, resulting in a net proceeds of USD 6,826,974 - USD 526,974 = USD 6,300,000. Again, this is the same amount that would be received by selling 4.20 million gallons of heating oil at USD 1.5000/gal.
As can be seen from the above examples, the downside of the short hedge is that the heating 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 heating oil prices while still be able to benefit from a rise in heating oil price is to buy heating oil put options.
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