The Fundamentals of Oil & Gas Hedging - Futures
This post 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) 5,000 BBLs of your November production. To hedge this production with futures, you could sell five (1 contract = 1,000 BBLs) December crude oil futures contracts.
You would sell the December, rather than the November futures contracts, because the November futures contract expires during the production month of October. However, the December futures contract will expire during the middle of the November production month so to properly hedge November production you would likely utilize a combination of December and January 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 Brent crude oil futures on Friday, you would have hedged 5,000 BBLs of your November production at approximately $66.46/BBL.
Let's now assume that it is November 13, the expiration date of the December Brent crude oil futures
contract. Because you do not want to make delivery of the futures contracts, you buy back five December futures contracts at the prevailing market price.
To compare how your strategy will work if the December Brent crude oil futures contract settles at prices both above and below your price of $66.46, 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 December Brent crude oil futures contracts, is $77/BBL, which is $10.54/BBL higher than the price at which you sold the futures contracts. In this scenario, you would receive approximately $77/BBL for your November crude oil production. However, your net price would be $66.46, the price at which you originally sold the futures contracts, excluding the basis differential, gathering and transportation fees, etc. This is because you would incur a loss of $10.54/BBL ($66.46 - $77.00 = -$10.54) on the futures contracts.
In the second scenario, let's assume that the prevailing market price, at which you buy back the December Brent crude oil futures contracts, is $55/BBL, which is $11.46/BBL lower than the price at which you sold the futures contracts. In this scenario, you would receive approximately $55/BBL for your November crude oil production. However, similar to the first scenario, your net price would be $66.46/BBL, again excluding the basis differential, gathering and transportation fees. This is because you would incur a gain of $11.46/BBL ($66.46 - $55.00 = $11.46) on the futures contracts.
While there are numerous details that need to be considered before you hedge your crude oil or natural gas 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 or natural gas prices, you can do so by selling a crude oil or natural gas 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 2013 and has recently been updated to better reflect current market conditions.
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