Hedging Oil Consumption - Essay Example

? HEDGING OIL CONSUMPTION Table of Contents Question 3 Question 2) 5 Question 3) 7 References 9 Question In today’s competitive world the market has become very volatile and it is becoming extremely difficult for the companies to predict demand successfully. The very basics of economics states that the prices of goods and services depend on the forces of demand and supply. When the demand for goods and services increases the prices are expected to increase in future and vice-versa. But in the competitive market where there are many participants, especially in a globalised world, possible rise of production cost could adversely affect production margins if the companies are not able to pass on the higher cost of production to their customers in fear losing them to rivals. There are other inherent risks associated with business such as currency fluctuations, volatility of crude oil prices and so on. In order to reduce exposure to volatility in the market, many participants prefer hedging strategies using derivatives. A derivative is a financial instrument which derives its value from the underlying asset. One of the hedging strategies alternatives that are available to the market participants is by using futures derivative. The main purpose of futures markets is to minimise uncertainty in transactions and hence reduce risk. The basic objective of futures market is to hedge the associated risk by taking such a position so as to neutralize possibility of risk as far practicable. A futures contact is a standard contract between two market participants to buy or sell a specific asset of standard quality, quantity for a given price agreed upon on the date of contract (also known as strike price) with payment and delivery occurring at maturity date. The contracts are standard in the sense that quantity, quality, price, strike price, delivery date, initial margin, marking to market, etc. are done via intermediary and not directly negotiated between parties involved in transaction. Hence, the refinery may enter into futures contract with its customers giving them the opportunity to purchase oil at current prices at a later date in future. In this way even if the prices of oil rises in future, the refinery would not require to pass on the higher costs to their customers (CME, 2006, pp.49-53). After discussing the concept of futures, it is now important to illustrate how futures might help the US Gulf refinery to hedge risk. There are two different methods of hedging namely short hedge and long hedge. A short hedge is suitable when the hedger owns the asset (as in this case) and expects it to sell at some time in future. Thus, the oil refinery may take short position in futures contract. A long hedge on the other hand involves taking the long position (buy at later date). This strategy is suitable when the hedger (in this case customer) knows that it will have to purchase a particular asset in future but would like to purchase at current price. In both the strategies payment and deliver occurs at maturity of contact which is usually three months. To further illustrate these strategies in details, consider the following example: Assuming that on June 13 (present) the oil refinery has taken a short position by negotiating a contract to sell 1 million barrels of crude oil. It is also agreed that the price applicable in the contract will be on the market price of September 13. So, for each 1% rise, the producer will gain $10,000 and similarly for each 1% decline in price refinery will lose $10,000. The standard futures contract on CME platform is 1,000 US barrels (or 42,000 gallons), hence the company can hedge exposure by shorting 1,000 September futures contracts. If the last trading close price was $90 per barrel, strike price is $85 and assuming that price per barrel in September is actually $80, then per barrel gain of the oil refinery would be $5 (since, $85 - $80). This means the total gains for entire contract would be $5000 ($5 x 1000). Using the above example the long hedge strategy can be explained as follow: In order to explain the benefit of reducing risk using long hedge strategy, it may be assumed that everything remaining constant except the price per barrel in September is actually $95 instead of $80. In this scenario, the worst has happened since the company feared rise of crude prices in future. But, with the help of long hedge the customers will be able to purchase crude at strike price and the gain per barrel will be $10 ($95 - $85). The total gain of the customers for 1,000 barrels will be $10,000 (Hull, 2009, pp.70-72). So, from the above discussion it can be said that hedging through futures will help the oil refinery to reduce risk of rising oil prices in future. Question 2) In order to determine the number of futures contract required to hedge the risk the concept stock index futures can be used which is appropriate for any well diversified equity portfolio of assets. The stock index futures can also be used to reduce the systematic risk and protect the portfolio from uncertain market volatility. The formula used to determine the number of contracts is given by, N* = (Va / Vf) x B; Where, Va = Current value of portfolio Vf = Current value of one future contract The above formula assumes that maturity of future contract and maturity of hedge is approximately close. Assuming that the US Gulf oil refinery requires taking short position and the fund manager manages stocks worth $5 million that needs to be hedged, then at current S&P index value of 1000.00 and portfolio beta of 1, the number of contracts required to be hedged = ($5,000,000/(1000.00*500))*1 = 10 contracts. Thus, the fund manager may sell (short) 10 contracts to cover its position (Hull, 2009, pp.80-85). There are two possible scenarios in this strategy which is explained as follows: Stock Market Movement Market falls 10% Market rises 10% Stock Portfolio Change Loss Gain   11% x $5,000,000 11% x $5,000,000   ($550,000) $550,000 Index Change Down 10% Up 10%   10 x (1000-900) x $500 10 x (1000-1100) x $500   $500,000 ($500,000) Net Change Loss Gain   ($50,000) $50,000 From the above table it can be said that by using index futures hedging strategy the refinery will be able to eliminate the risk arising from uncertain market movements and thus the underlying asset will depend on performance of portfolio relative to market. Contract Expiry Price Volume Open Interest (OI) FESX 6/13/2013 2650 1,094,493 2,460,912 FESX 9/13/2013 2639 738 7388 The price of futures contract that will expire in June is priced at 2650 and the futures contract expiring in September is at 2639. If the fund manager has to hedge a portfolio worth $100 m against a fall in Euro Stoxx 50 index, the fund manager may use stock index futures contract to reduce risk of price fluctuations. The number of contracts required to hedge can be calculated as follows: At current index price of 2695, number of contracts = (1,000,000) / (10 x 2695) = 3711 contracts At June 13 price of 2650, number of contracts = (1,000,000) / (10 x 2650) = 3774 contracts At September 13 price of 2639, number of contracts = (1,000,000) / (10 x 2650) = 3789 contracts The oil refinery is advised to short hedge by shorting 3774 contracts of June 13 futures as such strategy will help the portfolio to gain when the index falls by offsetting the risk of down trend in market and vice-versa. From the above table it is also apparent that the volume of June futures is higher implying higher liquidity. Hence, in case the index fall the oil producer will still be protected from losses as close price is nearest to spot price. Question 3) According to the given scenario, US Gulf coast oil refiner refines about 500,000 barrels of oil per month into Heating Oil and Gasoline. The refinery is concerned that in future they may experience higher production cost due to which oil prices is expected to rise. The main risk associated with such scenario is that the refinery expects that rising oil prices may potentially affect the production margins as the refinery fears it will not be able to pass on the higher costs to their customers. In addition to above mentioned risk of volatility in oil prices there are certain other risks associated with futures hedging including basis risk and liquidity risk. In futures contract the basis risk arises when the maturity of underlying asset does not match with the maturity of the contract or the asset which is required to be hedged is not the same as underlying asset. It can be calculate from the difference of spot price of asset to be hedged and future price of contract. This means that basis risk will be zero when the maturity of asset that needs to be hedged is the same as that of the future contract’s maturity (Hull, 2009, p.75). The mismatch of timing between hedged cash flow and the cash flow being hedged exerts pressure on cash flow and subsequently create liquidity risk. It is also important to note that market participants may not require hedging at all in the event the prise remains stable during the maturity period of contract. In that case, the margin money paid up front at the time of entering the contract will be loss for the hedger. The investor should keep in mind that the basic objective of hedging is not maximising profits but to minimise uncertainties in transactions and reduce risk. References Hull, J. C., 2009. Options, Futures, and Other Derivatives. [Pdf]. Available at: http://www.cup.edu.cn/sba/document/20091027224839825131.pdf. [Accessed on August 07, 2013]. CME, 2006. An Introduction to Futures and Options. [Pdf]. Available at: http://www.cmegroup.com/files/intro_fut_opt.pdf. [Accessed on August 07, 2013]. Read More