Given the recent volatility in crude oil and refined products prices, as well as natural gas prices, we thought it would be beneficial to take another look at the various energy hedging instruments available to the various participants in the energy commodity markets.
As this post will be the first of several in a series, we are going to begin by exploring how market participants can hedge their energy price risk with futures contracts, the underlying benchmarks of nearly all energy price risk management instruments. In subsequent posts we'll address energy commodity swaps, options and more complex hedging structures such as basis swaps, collars and spreads on options.
In the global energy commodity markets there are six primary energy futures contracts, four of which are traded on the NYMEX: WTI crude oil, Henry Hub natural gas, ultra-low sulfur diesel and gasoline and two of which are traded on ICE: Brent crude oil and gasoil.
Note: Clicking on any of the above mentioned products will take you to appropriate page on the NYMEX or ICE website which provides the contract specifications and description for each respective product.
In essence, a futures contract gives the buyer the right to buy the underlying commodity at the price at which he buys the futures contract and vice versa for the seller. However, in practice, very few energy futures contracts actually result in delivery, most are utilized for hedging and are exited, sold in the case of long positions, bought in the case of long positions, prior to expiration.
Now, let's get to the meat of the issue at hand, how can a company use energy futures to hedge their energy price risk?
Let’s examine the case of a natural gas producer who wants to "lock in" the price of their future production in a given month. For sake of simplicity, let's assume that the producer is looking to hedge (by "fixing" or "locking" in the price) 10,000 MMBtu of their September production. To hedge their 10,000 MMBtu they could sell one NYMEX natural gas futures contract. If you had sold this one natural gas futures contract based on the closing price yesterday, contract at they would have hedged 10,000 MMBtu of their September production for $2.712/MMBtu.
Let’s now assume that it is August 29, the expiration date of the September natural gas futures contract. Because the producer does not want to make delivery of the futures contract the producer decides to buy back one September natural gas futures contract at the then, prevailing market price. As an aside, if held to expiration, the seller (short) of a futures contract is obligated to make delivery of the commodity while the buyer (long) of a futures contract is required to take delivery of (receive) the commodity.
On August 29, if the prevailing market price, the price at which the producer bought back the natural gas futures contact, is $3.00/MMBtu, the producer would incur a hedging "loss" of $0.50/MMBtu. As a result (excluding the basis differential, transportation and gathering fees) the producer would receive $3.00/MMBtu for their physical natural gas. However, due to the hedging loss of $0.288/MMBtu, the producer’s gross profit for September would be $2.712/MMBtu, the price at which they originally sold the futures contract.
On the other hand, if on August 29 the prevailing market price is $2.50/MMBtu, the producer would incur a hedging "gain" of $0.212/MMBtu. In this scenario (again excluding the basis differential, transportation and gathering fees) the producer would receive $2.50/MMBtu for their physical natural gas. Due to the hedging gain of $0.212/MMBtu, the producer’s gross profit in this scenario would be also be $2.712/MMBtu, the price at which they originally sold the futures contract.
This same methodology also applies to oil and gas producers hedging their crude oil production with NYMEX or Brent Crude oil futures. Likewise, a similar but opposite methodology would apply to a natural gas end-user (consumer) who needs to hedge their exposure to potentially higher (rather than lower in the case of the producer) natural gas prices but rather than selling natural gas futures, as was the case with the producer, the consumer would buy a natural gas futures contract.
Similarly, an end-user who needs to hedge their exposure to gasoline can hedge buy buying gasoline (RBOB) or diesel fuel could do so by purchasing a gasoline or diesel fuel futures contract.
While there are a quite a few details that need to be considered before a company buys or sells futures contracts to hedge energy commodity price risk, the methodology is pretty straightforward: If you need to hedge your exposure against potentially higher energy prices you can do so by buying an energy futures contact, if you need to hedge your exposure to declining energy prices you can do so by selling an futures contract.
UPDATE: This post is the first in an introductory series on energy hedging. The subsequent four posts can be found via the following links:
In the meantime, if you would like to learn how we can assist you in hedging your energy price risk, please feel free to contact us.
Editor's Note: This post was first published in March 2011 and has recently been updated to better reflect current market conditions.