The trader uses a collar technique to hedge his position, which entails buying an at-the-money Weekly put option and selling an out-of-the-money Weekly call option with the same expiry. By selling the call, the trader can protect against downside risk while lowering the cost of the method.
How do oil firms use futures to protect themselves?
Oil demand is recovering from the pandemic’s destruction of demand, but output has not kept pace, causing prices to rise. Crude futures are trading around three-year highs above $73 a barrel, and some analysts say oil might touch $100. In the past, as oil prices rose, shale companies increased output and hedges, anxious to lock in profits.
Hedging is a strategy used by oil firms to protect themselves from price drops. They guarantee a specific sale price at a later date by buying or selling later-dated futures and options contracts. However, after a rush of activity in early June, U.S. shale businesses have backed off from hedging due to the rapidity of the post-pandemic surge.
How do you protect yourself from rising oil prices?
- To safeguard their bottom lines from volatile oil costs, airlines can use a variety of hedging tactics.
- Buying current oil contracts, which lock in gasoline purchases at today’s prices, is one straightforward option. If you predict prices to climb in the future, this is advantageous.
- When an airline purchases a swap contract, it is bound by the conditions of the deal.
How do you use futures to hedge?
Corporations typically participate in the futures market in order to lock in a better price ahead of a transaction. A company may elect to take a long position in a futures contract if it thinks it will need to purchase a specific item in the future. A long position is when you acquire a stock, commodity, or currency with the hopes of seeing its value rise in the future.
Is it possible to use futures to hedge?
Both consumers and producers of commodities can utilize futures contracts to hedge their positions. Futures hedging essentially locks in a commodity’s price today, even if it will be bought or sold in physical form in the future.
What is the duration of an oil futures contract?
You’re not going to the store and buying a couple thousand 55-gallon barrels of crude oil to store in your backyard, are you? That’s just not feasible.
Crude oil futures contracts were created to allow oil corporations and companies that consume a lot of oil to plan delivery of the commodity at a set price and date. Today, these contracts are also traded between speculators who expect to profit from the commodity’s volatility.
On the futures market, these derivatives are a hot commodity, with the potential to yield large gains in a short period of time. Unfortunately, when bad decisions are made, the consequences can be just as severe.
The majority of oil futures contracts include the purchase and sale of 1,000 barrels of crude oil. When a contract is purchased, it stipulates that these barrels of oil will be delivered at a certain date (up to nine years away) and for a predetermined price at a predetermined date (or expiration date).
Let’s imagine you bought an oil futures contract today with a three-month expiration date; you’d be owed 1,000 barrels of oil three months from now, but you’d pay today’s price let’s say $50 per barrel as an example.
You notice that the price of oil has climbed to $51 per barrel in 30 days, indicating that your futures contract is now worth $1,000 more than you paid. If the price of oil fell to $49 per barrel, on the other hand, you would have lost $1,000.
In either case, you’ll want to sell as soon as possible when the contract expires. Individual investors and price speculators who aren’t large-scale crude oil users typically close off futures contracts well before they expire.
- You’re probably not going to be able to store 1,000 barrels of oil. You probably don’t have enough room to store 55,000 gallons of oil. If you own the contract when it expires, you’ll have to decide where to store the oil and what to do with it. Your entire investment is gone if you opt not to take ownership.
- Futures contracts lose value as they get closer to expiration. The futures market operates at a breakneck speed, with the thrill being in forecasting what will happen in a week rather than when the contract will expire. The premium paid for future value growth decreases as the contract approaches its expiration date. As a result, holding these contracts for too long will limit your prospective gains.
Pro tip: If you want to invest in oil futures, you should open an account with a broker who specializes in future contracts. When you open an account with TradeStation, you can get a $5,000 registration bonus.
Why are futures contracts becoming increasingly popular?
Because futures contracts are exchanged on exchanges, unlike forwards, which are negotiated privately between counterparties, their details are made public. Futures have a lower counterparty risk than forward contracts because they are regulated. These contracts are also standardized, meaning they have predetermined terms and an expiration date. Forwards, on the other hand, are tailored to the parties’ specific requirements.
Is JetBlue hedging its fuel costs?
JetBlue’s hedging strategy for fuel had changed over time (Exhibit 3). Fuel hedging was handled by the corporation on a discretionary basis, with no specific aims in mind. When oil prices were low in 2009, it hedged less, then increased the percentage hedged in 2010 and 2011.
What is the process of hedging?
- Hedging is a risk management approach that involves acquiring an opposing position in a comparable asset to balance investment losses.
- Hedging often results in a reduction in prospective profits due to the reduction in risk it provides.
- Hedging necessitates the payment of a premium in exchange for the protection it provides.
- Derivatives, such as options and futures contracts, are commonly used in hedging tactics.
What is Bunker hedging, and how does it work?
In recent weeks, we’ve spoken with a number of bunker fuel consumers (cruise lines, shipping companies, and so on) that are looking for “more innovative” hedging techniques to mitigate their bunker fuel price risk.
Most bunker fuel users have traditionally hedged via fixed price swaps, call options, and costless collars. While these three instruments are typically good hedging methods, they each have their own set of disadvantages. Fixed price swaps, on the other hand, can result in losses if prices fall. Call options are risk-free (with the exception of basis and credit risk), but they do demand an upfront premium payment, which can be substantial. Costless collars can give good protection against growing prices, but they also present downside price risk via the sale of a put option, comparable to a fixed price swap.
Today, we’ll look at a three-way consumer collar, which is another bunker fuel hedging method.
A three-way consumer collar combines a regular, cost-free consumer collar with the purchase of an additional put option, reducing the danger of being short a put option and being exposed to falling prices.
Let’s say a cruise line is considering hedging their July Asian fuel use with a consumer costless collar on Singapore 380 fuel oil, with a top (call option) of $610/MT and a floor (put option) of $590/CT. If Singapore 380 fuel oil averages more than $610/MT for the month of July, the cruise line will benefit from hedging gains. During the month of July, if Singapore 380 fuel oil averages less than $590/CT, the corporation will face hedging losses. The corporation will not experience any hedging benefits or losses if Singapore 380 fuel oil averages more than $590/MT but less than $610/MT in July; instead, they will be exposed to spot market prices. Clearly, this method works well while prices are stable or rising, but it does not work well when prices fall dramatically, as they did in this case below $590/MT.
If the cruise lines prefer to use a more conservative hedging approach, they can buy an additional put option (floor) that limits their maximum loss to the difference between $590 and the strike price of the additional put option.
Continuing with the previous example, if the cruise hedged with the same costless collar ($610 cap and $590 floor) and also purchased an additional put option (floor) at $570/MT for a premium of $3.00/MT, their risk would be limited to $20/MT ($590 – $570 = $20), plus an up front premium (out of pocket) cost of $3.00/MT if Singapore 380 fuel oil prices average less than $590/MT during the month of July.
To be more specific, if Singapore 380 fuel oil prices averaged $525/MT, the cruise line would lose $65/MT on the $590 put option and gain $45/MT on the $570 put option, resulting in a net loss of $20/MT.
The classic, costless collar, as shown in the chart above, saves the cruise line money on bunker fuel when Singapore 380 fuel oil prices average more than $610/MT, as well as when they are within the collar’s range or near the $590 floor.
The three-way collar, on the other hand, is a better hedging strategy than the costless collar if Singapore 380 fuel oil prices fall dramatically and average $567 ($570 – the $3 premium for the additional option) or less. To put it another way, if the cruise line is ready to tolerate the risk of being short the $590 put option, and Singapore fuel oil is averaging less than $590/MT, a costless collar may be the best hedging strategy for them. A three-way collar, on the other hand, might be an ideal hedging strategy for a more conservative company that needs to ensure that any hedging losses are kept to a minimum, especially in a fragile economic environment like the current one, as it provides an excellent hedge against higher prices while limiting losses in a low price environment.
While this post focuses on using three-way collars to hedge bunker fuel, the same process may be used to hedge crude oil, diesel fuel, gasoline, gasoil, jet fuel, NGLs, and other commodities.
If you’re interested in learning more about bunker fuel hedging, check out the following articles:
How do futures contracts protect you against risk?
Hedging is the practice of buying or selling futures contracts to safeguard against the risk of losing money due to fluctuating cash market prices. If you’re feeding hogs to market, you’ll want to hedge against dropping cash market prices. If you need to buy feed grain, you’ll want to hedge against rising cash market prices.