Businesses that need to buy significant quantities of natural gas can hedge against rising natural gas price by taking up a position in the natural gas futures market.
These companies can employ what is known as a long hedge to secure a purchase price for a supply of natural gas that they will require sometime in the future.
To implement the long hedge, enough natural gas futures are to be purchased to cover the quantity of natural gas required by the business operator.
A power company will need to procure 1.00 million mmbtus of natural gas in 3 months' time. The prevailing spot price for natural gas is USD 5.5150/mmbtu while the price of natural gas futures for delivery in 3 months' time is USD 5.5000/mmbtu. To hedge against a rise in natural gas price, the power company decided to lock in a future purchase price of USD 5.5000/mmbtu by taking a long position in an appropriate number of NYMEX Natural Gas futures contracts. With each NYMEX Natural Gas futures contract covering 10000 mmBtus of natural gas, the power company 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 power company will be able to purchase the 1.00 million mmbtus of natural gas at USD 5.5000/mmbtu for a total amount of USD 5,500,000. Let's see how this is achieved by looking at scenarios in which the price of natural gas makes a significant move either upwards or downwards by delivery date.
With the increase in natural gas price to USD 6.0665/mmbtu, the power company will now have to pay USD 6,066,500 for the 1.00 million mmbtus of natural gas. However, the increased purchase price will be offset by the gains in the futures market.
By delivery date, the natural gas futures price will have converged with the natural gas spot price and will be equal to USD 6.0665/mmbtu. As the long futures position was entered at a lower price of USD 5.5000/mmbtu, it will have gained USD 6.0665 - USD 5.5000 = USD 0.5665 per mmbtu. With 100 contracts covering a total of 1.00 million mmbtus of natural gas, the total gain from the long futures position is USD 566,500.
In the end, the higher purchase price is offset by the gain in the natural gas futures market, resulting in a net payment amount of USD 6,066,500 - USD 566,500 = USD 5,500,000. This amount is equivalent to the amount payable when buying the 1.00 million mmbtus of natural gas at USD 5.5000/mmbtu.
With the spot price having fallen to USD 4.9635/mmbtu, the power company will only need to pay USD 4,963,500 for the natural gas. However, the loss in the futures market will offset any savings made.
Again, by delivery date, the natural gas futures price will have converged with the natural gas spot price and will be equal to USD 4.9635/mmbtu. As the long futures position was entered at USD 5.5000/mmbtu, it will have lost USD 5.5000 - USD 4.9635 = USD 0.5365 per mmbtu. With 100 contracts covering a total of 1.00 million mmbtus, the total loss from the long futures position is USD 536,500
Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the natural gas futures market and the net amount payable will be USD 4,963,500 + USD 536,500 = USD 5,500,000. Once again, this amount is equivalent to buying 1.00 million mmbtus of natural gas at USD 5.5000/mmbtu.
As you can see from the above examples, the downside of the long hedge is that the natural gas buyer would have been better off without the hedge if the price of the commodity fell.
An alternative way of hedging against rising natural gas prices while still be able to benefit from a fall in natural gas price is to buy natural gas call options.
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