what does the term hedging mean? why do companies elect to follow this strategy?
This commodity is the first in a serial where we explore the most mutual strategies utilzed by oil and gas producers to hedge their exposure to crude oil, natural gas and NGL prices. In the free energy markets in that location are vi principal energy futures contracts, four of which are traded on the New York Mercantile Exchange (NYMEX): WTI rough oil, Henry Hub natural gas, NY Harbor ultra-low sulfur diesel (formerly heating oil) and RBOB gasoline and two of which are traded on the IntercontinentalExchange (Water ice): Brent crude oil and gasoil. A futures contract gives the heir-apparent of the contract, the right and obligation, to buy the underlying commodity at the price at which he buys the futures contract. Conversely, a futures contract gives the seller of the contract, the right and obligation, to sell the underlying commodity at the price at which he sells the futures contract. However, in practice, very few commodity futures contracts actually result in delivery, nearly are utilized for hedging and are sold or bought back prior to expiration. So how tin an oil and gas producer utilise futures contracts to hedge their exposure to volatile oil and gas prices? Every bit an example, let's assume that you are a crude oil producer who wants to hedge the price of your future crude oil production. For sake of simplicity, let's assume that yous are looking to hedge (by "fixing" or "locking" in the price) your July crude oil production. To hedge this production with futures, y'all could sell (brusque) a September ICE Brent crude oil futures contract. We are using Water ice Brent futures in this example as ICE Brent is the global benchmark for crude oil but, most producers in the Americas would be likely be inclined to utilized NYMEX WTI futures rather than ICE Brent futures. Yous would sell the September, rather than the July or Baronial, futures contract because the September futures contract expires during the July production month. Per the contract specifications for Water ice Brent crude oil, "Trading shall cease at the end of the designated settlement period on the last Concern Twenty-four hours of the second calendar month preceding the relevant contract month". This scenario, which is known as "calendar ground risk" in trading jargon, is the reason many oil and gas producers hedge with swaps rather than futures. We'll too accost calendar footing risk in more than depth in some other post in the not too distant hereafter. For sake of this case, let'south presume that to hedge your July production that you lot simply sold one September ICE Brent rough oil futures contract. If y'all had done so yesterday, based on the closing price of September Ice Brent rough oil futures, you would have hedged your July production at approximately $61.90/BBL. Let'due south now assume that it is July xix, the expiration appointment of the September Water ice Brent crude oil futures contract. Because you practise not desire to make delivery of the futures contract, yous buy back the September futures contract at the prevailing market toll to close out your position. To compare how your strategy will work if the September crude oil futures contract settles at prices both above and below your price of $61.90, let's examine the following ii scenarios. In the first scenario, let'due south assume that the prevailing market cost, at which you buy back the September Brent crude oil futures contract, is $65/BBL, which is $three.ten/BBL higher than the cost at which you sold the futures contract. In this scenario, you would receive approximately $65/BBL for your July crude oil production. Even so, your net revenue would be $61.xc, the price at which you originally sold the futures contract, excluding the basis differential, gathering and transportation fees, etc. This is because yous would incur a loss of $3.10/BBL ($65.00 - $61.ninety = $3.10) on the futures contract. In the 2nd scenario, let'south assume that the prevailing market price, at which you lot buy back the September Brent rough oil futures contract, is $50/BBL, which is $11.90/BBL lower than the cost at which you sold the futures contract. In this scenario, you lot would receive approximately $50/BBL for your July crude oil product. However, your net revenue would exist approximately $61.ninety/BBL, once again excluding the basis differential, gathering and transportation fees. This is because yous would incur a gain of $xi.90/BBL ($61.ninety - $sixty.00 = $11.ninety) on the futures contract. While there are numerous variables that must be considered before you hedge your rough oil, natural gas or NGL production with futures, the basic methodology is rather elementary: if you are an oil and gas producer and demand or want to hedge your exposure to crude oil, natural gas or NGL prices, you can do so by selling (short) a futures contract. Last merely not least, while this example addressed how a rough oil producer can hedge with futures, ane can employ like methodologies to hedge the product of other commodities equally well. This post is the first in a series on hedging crude oil, natural gas and natural gas liquids production. The subsequent posts can exist viewed via the following links:
Source: https://www.mercatusenergy.com/blog/bid/86597/the-fundamentals-of-oil-gas-hedging-futures
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