The Fundamentals of Oil & Gas Hedging - Futures

This article is the first in a series where we explore the most common strategies utilzed by oil and gas producers to hedge their exposure to crude oil, natural gas and NGL prices.  

In the energy markets there are six primary energy futures contracts, four of which are traded on the New York Mercantile Exchange (NYMEX): WTI crude 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 (ICE): Brent crude oil and gasoil. 

A futures contract gives the buyer 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, most are utilized for hedging and are sold or bought back prior to expiration. 

So how can an oil and gas producer utilize futures contracts to hedge their exposure to volatile oil and gas prices? As 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 you are looking to hedge (by "fixing" or "locking" in the price) your July crude oil production. To hedge this production with futures, you could sell (short) a September ICE Brent crude oil futures contract. We are using 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.

You would sell the September, rather than the July or August, futures contract because the September futures contract expires during the July production month. Per the contract specifications for ICE Brent crude oil, "Trading shall cease at the end of the designated settlement period on the last Business Day of the second month preceding the relevant contract month". This scenario, which is known as “calendar basis risk” in trading jargon, is the reason many oil and gas producers hedge with swaps rather than futures. We’ll also address calendar basis risk in more depth in another post in the not too distant future.

For sake of this example, let's assume that to hedge your July production that you simply sold one September ICE Brent crude oil futures contract. If you had done so yesterday, based on the closing price of September ICE Brent crude oil futures, you would have hedged your July production at approximately $61.90/BBL.

 

ICE-Brent-crude-oil-futures-forward-curve-chart

Let's now assume that it is July 19, the expiration date of the September ICE Brent crude oil futures contract. Because you do not want to make delivery of the futures contract, you buy back the September futures contract at the prevailing market price 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 two scenarios.

In the first scenario, let's assume that the prevailing market price, at which you buy back the September Brent crude oil futures contract, is $65/BBL, which is $3.10/BBL higher than the price at which you sold the futures contract. In this scenario, you would receive approximately $65/BBL for your July crude oil production. However, your net revenue would be $61.90, the price at which you originally sold the futures contract, excluding the basis differential, gathering and transportation fees, etc. This is because you would incur a loss of $3.10/BBL ($65.00 - $61.90 = $3.10) on the futures contract.

ice-brent-crude-oil-futures-producer-hedging-example

In the second scenario, let's assume that the prevailing market price, at which you buy back the September Brent crude oil futures contract, is $50/BBL, which is $11.90/BBL lower than the price at which you sold the futures contract. In this scenario, you would receive approximately $50/BBL for your July crude oil production. However, your net revenue would be approximately $61.90/BBL, again excluding the basis differential, gathering and transportation fees. This is because you would incur a gain of $11.90/BBL ($61.90 - $60.00 = $11.90) on the futures contract.

While there are numerous variables that must be considered before you hedge your crude oil, natural gas or NGL production with futures, the basic methodology is rather simple: if you are an oil and gas producer and need 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 but not least, while this example addressed how a crude oil producer can hedge with futures, one can employ similar methodologies to hedge the production of other commodities as well.

This post is the first in a series on hedging crude oil, natural gas and natural gas liquids production.  The subsequent posts can be viewed via the following links: