Hedging Against Falling Heating Oil Prices using Heating Oil Futures

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Contents

Hedging Against Falling Crude Oil Prices using Crude Oil Futures

Crude Oil producers can hedge against falling crude oil price by taking up a position in the crude oil futures market.

Crude Oil producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of crude oil that is only ready for sale sometime in the future.

To implement the short hedge, crude oil producers sell (short) enough crude oil futures contracts in the futures market to cover the quantity of crude oil to be produced.

Crude Oil Futures Short Hedge Example

An oil extraction company has just entered into a contract to sell 100,000 barrels of crude oil, to be delivered in 3 months’ time. The sale price is agreed by both parties to be based on the market price of crude oil on the day of delivery. At the time of signing the agreement, spot price for crude oil is USD 44.20/barrel while the price of crude oil futures for delivery in 3 months’ time is USD 44.00/barrel.

To lock in the selling price at USD 44.00/barrel, the oil extraction company can enter a short position in an appropriate number of NYMEX Brent Crude Oil futures contracts. With each NYMEX Brent Crude Oil futures contract covering 1,000 barrels of crude oil, the oil extraction company will be required to short 100 futures contracts.

The effect of putting in place the hedge should guarantee that the oil extraction company will be able to sell the 100,000 barrels of crude oil at USD 44.00/barrel for a total amount of USD 4,400,000. Let’s see how this is achieved by looking at scenarios in which the price of crude oil makes a significant move either upwards or downwards by delivery date.

Scenario #1: Crude Oil Spot Price Fell by 10% to USD 39.78/barrel on Delivery Date

As per the sales contract, the oil extraction company will have to sell the crude oil at only USD 39.78/barrel, resulting in a net sales proceeds of USD 3,978,000.

By delivery date, the crude oil futures price will have converged with the crude oil spot price and will be equal to USD 39.78/barrel. As the short futures position was entered at USD 44.00/barrel, it will have gained USD 44.00 – USD 39.78 = USD 4.2200 per barrel. With 100 contracts covering a total of 100000 barrels, the total gain from the short futures position is USD 422,000

Together, the gain in the crude oil futures market and the amount realised from the sales contract will total USD 422,000 + USD 3,978,000 = USD 4,400,000. This amount is equivalent to selling 100,000 barrels of crude oil at USD 44.00/barrel.

Scenario #2: Crude Oil Spot Price Rose by 10% to USD 48.62/barrel on Delivery Date

With the increase in crude oil price to USD 48.62/barrel, the crude oil producer will be able to sell the 100,000 barrels of crude oil for a higher net sales proceeds of USD 4,862,000.

However, as the short futures position was entered at a lower price of USD 44.00/barrel, it will have lost USD 48.62 – USD 44.00 = USD 4.6200 per barrel. With 100 contracts covering a total of 100,000 barrels of crude oil, the total loss from the short futures position is USD 462,000.

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In the end, the higher sales proceeds is offset by the loss in the crude oil futures market, resulting in a net proceeds of USD 4,862,000 – USD 462,000 = USD 4,400,000. Again, this is the same amount that would be received by selling 100,000 barrels of crude oil at USD 44.00/barrel.

Risk/Reward Tradeoff

As can be seen from the above examples, the downside of the short hedge is that the crude oil seller would have been better off without the hedge if the price of the commodity went up.

An alternative way of hedging against falling crude oil prices while still be able to benefit from a rise in crude oil price is to buy crude oil put options.

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Hedging Against Rising Heating Oil Prices using Heating Oil Futures

Businesses that need to buy significant quantities of heating oil can hedge against rising heating oil price by taking up a position in the heating oil futures market.

These companies can employ what is known as a long hedge to secure a purchase price for a supply of heating oil that they will require sometime in the future.

To implement the long hedge, enough heating oil futures are to be purchased to cover the quantity of heating oil required by the business operator.

Heating Oil Futures Long Hedge Example

A heating oil distributor will need to procure 4.20 million gallons of heating oil in 3 months’ time. The prevailing spot price for heating oil is USD 1.4777/gal while the price of heating oil futures for delivery in 3 months’ time is USD 1.5000/gal. To hedge against a rise in heating oil price, the heating oil distributor decided to lock in a future purchase price of USD 1.5000/gal by taking a long position in an appropriate number of NYMEX Heating Oil futures contracts. With each NYMEX Heating Oil futures contract covering 42000 gallons of heating oil, the heating oil distributor 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 heating oil distributor will be able to purchase the 4.20 million gallons of heating oil at USD 1.5000/gal for a total amount of USD 6,300,000. Let’s see how this is achieved by looking at scenarios in which the price of heating oil makes a significant move either upwards or downwards by delivery date.

Scenario #1: Heating Oil Spot Price Rose by 10% to USD 1.6255/gal on Delivery Date

With the increase in heating oil price to USD 1.6255/gal, the heating oil distributor will now have to pay USD 6,826,974 for the 4.20 million gallons of heating oil. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the heating oil futures price will have converged with the heating oil spot price and will be equal to USD 1.6255/gal. As the long futures position was entered at a lower price of USD 1.5000/gal, it will have gained USD 1.6255 – USD 1.5000 = USD 0.1255 per gallon. With 100 contracts covering a total of 4.20 million gallons of heating oil, the total gain from the long futures position is USD 526,974.

In the end, the higher purchase price is offset by the gain in the heating oil futures market, resulting in a net payment amount of USD 6,826,974 – USD 526,974 = USD 6,300,000. This amount is equivalent to the amount payable when buying the 4.20 million gallons of heating oil at USD 1.5000/gal.

Scenario #2: Heating Oil Spot Price Fell by 10% to USD 1.3299/gal on Delivery Date

With the spot price having fallen to USD 1.3299/gal, the heating oil distributor will only need to pay USD 5,585,706 for the heating oil. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the heating oil futures price will have converged with the heating oil spot price and will be equal to USD 1.3299/gal. As the long futures position was entered at USD 1.5000/gal, it will have lost USD 1.5000 – USD 1.3299 = USD 0.1701 per gallon. With 100 contracts covering a total of 4.20 million gallons, the total loss from the long futures position is USD 714,294

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the heating oil futures market and the net amount payable will be USD 5,585,706 + USD 714,294 = USD 6,300,000. Once again, this amount is equivalent to buying 4.20 million gallons of heating oil at USD 1.5000/gal.

Risk/Reward Tradeoff

As you can see from the above examples, the downside of the long hedge is that the heating oil buyer would have been better off without the hedge if the price of the commodity fell.

An alternative way of hedging against rising heating oil prices while still be able to benefit from a fall in heating oil price is to buy heating oil call options.

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As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

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Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

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Hedging Against Falling Heating Oil Prices using Heating Oil Futures

This article is the first in a series where we will be exploring the most common strategies used 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. On the other hand, 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 October crude oil production. To hedge this production with futures, you could sell (short) a November crude oil futures contract.

You would sell the November, rather than the October futures contract, because the November futures contract expires during the production month of October. However, the November futures contract will expire during the middle of the October production month so to properly hedge October production you would likely utilize a combination of November and December futures contracts. This complexity, known as “calendar basis risk” in trading jargon, is the reason many oil and gas producers hedge with swaps rather than futures. We’ll address calendar basis risk in more depth in another post in the not too distant future.

If you had sold these futures based on the closing price of November WTI crude oil futures yesterday, you would have hedged your October production at approximately $46.93/BBL.

Let’s now assume that it is October 20, the expiration date of the November WTI crude oil futures contract. Because you do not want to make delivery of the futures contract, you buy back the November futures contract at the prevailing market price to close out your position.

To compare how your strategy will work if the November crude oil futures contract settles at prices both above and below your price of $46.93, 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 November WTI crude oil futures contract, is $60/BBL, which is $13.07/BBL higher than the price at which you sold the futures contract. In this scenario, you would receive approximately $60/BBL for your October crude oil production. However, your net revenue would be $46.93, 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 $13.07/BBL ($60.00 – $46.93 = $13.07) on the futures contract.

In the second scenario, let’s assume that the prevailing market price, at which you buy back the November WTI crude oil futures contract, is $35/BBL, which is $11.93/BBL lower than the price at which you sold the futures contract. In this scenario, you would receive approximately $35/BBL for your October crude oil production. However, similar to your net revenue would be $46.93/BBL, again excluding the basis differential, gathering and transportation fees. This is because you would incur a gain of $11.93/BBL ($46.93 – $35.00 = $11.93) on the futures contract.

While there are numerous variable 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 and natural gas production. The subsequent posts can be viewed via the following links:

Editor’s Note: The post was originally published in February 2020 and has recently been updated to better reflect current market conditions.

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