Kerosene producers can hedge against falling kerosene price by taking up a position in the kerosene futures market.
Kerosene producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of kerosene that is only ready for sale sometime in the future.
To implement the short hedge, kerosene producers sell (short) enough kerosene futures contracts in the futures market to cover the quantity of kerosene to be produced.
An oil refinery has just entered into a contract to sell 5,000 kiloliters of kerosene, to be delivered in 3 months' time. The sale price is agreed by both parties to be based on the market price of kerosene on the day of delivery. At the time of signing the agreement, spot price for kerosene is JPY 45,710/kl while the price of kerosene futures for delivery in 3 months' time is JPY 46,000/kl.
To lock in the selling price at JPY 46,000/kl, the oil refinery can enter a short position in an appropriate number of TOCOM Kerosene futures contracts. With each TOCOM Kerosene futures contract covering 50 kiloliters of kerosene, 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 kerosene at JPY 46,000/kl for a total amount of JPY 230,000,000. Let's see how this is achieved by looking at scenarios in which the price of kerosene makes a significant move either upwards or downwards by delivery date.
As per the sales contract, the oil refinery will have to sell the kerosene at only JPY 41,139/kl, resulting in a net sales proceeds of JPY 205,695,000.
By delivery date, the kerosene futures price will have converged with the kerosene spot price and will be equal to JPY 41,139/kl. As the short futures position was entered at JPY 46,000/kl, it will have gained JPY 46,000 - JPY 41,139 = JPY 4,861 per kiloliter. With 100 contracts covering a total of 5000 kiloliters, the total gain from the short futures position is JPY 24,305,000
Together, the gain in the kerosene futures market and the amount realised from the sales contract will total JPY 24,305,000 + JPY 205,695,000 = JPY 230,000,000. This amount is equivalent to selling 5,000 kiloliters of kerosene at JPY 46,000/kl.
With the increase in kerosene price to JPY 50,281/kl, the kerosene producer will be able to sell the 5,000 kiloliters of kerosene for a higher net sales proceeds of JPY 251,405,000.
However, as the short futures position was entered at a lower price of JPY 46,000/kl, it will have lost JPY 50,281 - JPY 46,000 = JPY 4,281 per kiloliter. With 100 contracts covering a total of 5,000 kiloliters of kerosene, the total loss from the short futures position is JPY 21,405,000.
In the end, the higher sales proceeds is offset by the loss in the kerosene futures market, resulting in a net proceeds of JPY 251,405,000 - JPY 21,405,000 = JPY 230,000,000. Again, this is the same amount that would be received by selling 5,000 kiloliters of kerosene at JPY 46,000/kl.
As can be seen from the above examples, the downside of the short hedge is that the kerosene seller would have been better off without the hedge if the price of the commodity went up.
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