Natural Gas producers can hedge against falling natural gas price by taking up a position in the natural gas futures market.
Natural Gas producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of natural gas that is only ready for sale sometime in the future.
To implement the short hedge, natural gas producers sell (short) enough natural gas futures contracts in the futures market to cover the quantity of natural gas to be produced.
A natural gas producer has just entered into a contract to sell 1.00 million mmbtus of natural gas, to be delivered in 3 months' time. The sale price is agreed by both parties to be based on the market price of natural gas on the day of delivery. At the time of signing the agreement, 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 lock in the selling price at USD 5.5000/mmbtu, the natural gas producer can enter a short position in an appropriate number of NYMEX Natural Gas futures contracts. With each NYMEX Natural Gas futures contract covering 10,000 mmBtus of natural gas, the natural gas producer will be required to short 100 futures contracts.
The effect of putting in place the hedge should guarantee that the natural gas producer will be able to sell 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.
As per the sales contract, the natural gas producer will have to sell the natural gas at only USD 4.9635/mmbtu, resulting in a net sales proceeds of USD 4,963,500.
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 short futures position was entered at USD 5.5000/mmbtu, it will have gained USD 5.5000 - USD 4.9635 = USD 0.5365 per mmbtu. With 100 contracts covering a total of 1000000 mmbtus, the total gain from the short futures position is USD 536,500
Together, the gain in the natural gas futures market and the amount realised from the sales contract will total USD 536,500 + USD 4,963,500 = USD 5,500,000. This amount is equivalent to selling 1.00 million mmbtus of natural gas at USD 5.5000/mmbtu.
With the increase in natural gas price to USD 6.0665/mmbtu, the natural gas producer will be able to sell the 1.00 million mmbtus of natural gas for a higher net sales proceeds of USD 6,066,500.
However, as the short futures position was entered at a lower price of USD 5.5000/mmbtu, it will have lost 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 loss from the short futures position is USD 566,500.
In the end, the higher sales proceeds is offset by the loss in the natural gas futures market, resulting in a net proceeds of USD 6,066,500 - USD 566,500 = USD 5,500,000. Again, this is the same amount that would be received by selling 1.00 million mmbtus of natural gas at USD 5.5000/mmbtu.
As can be seen from the above examples, the downside of the short hedge is that the natural gas seller would have been better off without the hedge if the price of the commodity went up.
An alternative way of hedging against falling natural gas prices while still be able to benefit from a rise in natural gas price is to buy natural gas put options.
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