Hedging Against Rising Kerosene Prices using Kerosene Futures

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Contents

Hedging Against Rising Kerosene Prices using Kerosene Futures

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

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

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

Kerosene Futures Long Hedge Example

A kerosene distributor will need to procure 5,000 kiloliters of kerosene in 3 months’ time. The prevailing spot price for kerosene is JPY 45,710/kl while the price of kerosene futures for delivery in 3 months’ time is JPY 46,000/kl. To hedge against a rise in kerosene price, the kerosene distributor decided to lock in a future purchase price of JPY 46,000/kl by taking a long position in an appropriate number of TOCOM Kerosene futures contracts. With each TOCOM Kerosene futures contract covering 50 kiloliters of kerosene, the kerosene 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 kerosene distributor will be able to purchase the 5,000 kiloliters of kerosene at JPY 46,000/kl for a total amount of JPY 230,000,000. Let’s see how this is achieved by looking at scenarios in which the price of kerosene makes a significant move either upwards or downwards by delivery date.

Scenario #1: Kerosene Spot Price Rose by 10% to JPY 50,281/kl on Delivery Date

With the increase in kerosene price to JPY 50,281/kl, the kerosene distributor will now have to pay JPY 251,405,000 for the 5,000 kiloliters of kerosene. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the kerosene futures price will have converged with the kerosene spot price and will be equal to JPY 50,281/kl. As the long futures position was entered at a lower price of JPY 46,000/kl, it will have gained JPY 50,281 – JPY 46,000 = JPY 4,281 per kiloliter. With 100 contracts covering a total of 5,000 kiloliters of kerosene, the total gain from the long futures position is JPY 21,405,000.

In the end, the higher purchase price is offset by the gain in the kerosene futures market, resulting in a net payment amount of JPY 251,405,000 – JPY 21,405,000 = JPY 230,000,000. This amount is equivalent to the amount payable when buying the 5,000 kiloliters of kerosene at JPY 46,000/kl.

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Scenario #2: Kerosene Spot Price Fell by 10% to JPY 41,139/kl on Delivery Date

With the spot price having fallen to JPY 41,139/kl, the kerosene distributor will only need to pay JPY 205,695,000 for the kerosene. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the kerosene futures price will have converged with the kerosene spot price and will be equal to JPY 41,139/kl. As the long futures position was entered at JPY 46,000/kl, it will have lost JPY 46,000 – JPY 41,139 = JPY 4,861 per kiloliter. With 100 contracts covering a total of 5,000 kiloliters, the total loss from the long futures position is JPY 24,305,000

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the kerosene futures market and the net amount payable will be JPY 205,695,000 + JPY 24,305,000 = JPY 230,000,000. Once again, this amount is equivalent to buying 5,000 kiloliters of kerosene at JPY 46,000/kl.

Risk/Reward Tradeoff

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

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Hedging Against Falling Kerosene Prices using Kerosene Futures

Kerosene producers can hedge against falling kerosene price by taking up a position in the kerosene futures market.

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

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

Kerosene Futures Short Hedge Example

An oil refinery has just entered into a contract to sell 5,000 kiloliters of kerosene, to be delivered in 3 months’ time. The sale price is agreed by both parties to be based on the market price of kerosene on the day of delivery. At the time of signing the agreement, spot price for kerosene is JPY 45,710/kl while the price of kerosene futures for delivery in 3 months’ time is JPY 46,000/kl.

To lock in the selling price at JPY 46,000/kl, the oil refinery can enter a short position in an appropriate number of TOCOM Kerosene futures contracts. With each TOCOM Kerosene futures contract covering 50 kiloliters of kerosene, the oil refinery will be required to short 100 futures contracts.

The effect of putting in place the hedge should guarantee that the oil refinery will be able to sell the 5,000 kiloliters of kerosene at JPY 46,000/kl for a total amount of JPY 230,000,000. Let’s see how this is achieved by looking at scenarios in which the price of kerosene makes a significant move either upwards or downwards by delivery date.

Scenario #1: Kerosene Spot Price Fell by 10% to JPY 41,139/kl on Delivery Date

As per the sales contract, the oil refinery will have to sell the kerosene at only JPY 41,139/kl, resulting in a net sales proceeds of JPY 205,695,000.

By delivery date, the kerosene futures price will have converged with the kerosene spot price and will be equal to JPY 41,139/kl. As the short futures position was entered at JPY 46,000/kl, it will have gained JPY 46,000 – JPY 41,139 = JPY 4,861 per kiloliter. With 100 contracts covering a total of 5000 kiloliters, the total gain from the short futures position is JPY 24,305,000

Together, the gain in the kerosene futures market and the amount realised from the sales contract will total JPY 24,305,000 + JPY 205,695,000 = JPY 230,000,000. This amount is equivalent to selling 5,000 kiloliters of kerosene at JPY 46,000/kl.

Scenario #2: Kerosene Spot Price Rose by 10% to JPY 50,281/kl on Delivery Date

With the increase in kerosene price to JPY 50,281/kl, the kerosene producer will be able to sell the 5,000 kiloliters of kerosene for a higher net sales proceeds of JPY 251,405,000.

However, as the short futures position was entered at a lower price of JPY 46,000/kl, it will have lost JPY 50,281 – JPY 46,000 = JPY 4,281 per kiloliter. With 100 contracts covering a total of 5,000 kiloliters of kerosene, the total loss from the short futures position is JPY 21,405,000.

In the end, the higher sales proceeds is offset by the loss in the kerosene futures market, resulting in a net proceeds of JPY 251,405,000 – JPY 21,405,000 = JPY 230,000,000. Again, this is the same amount that would be received by selling 5,000 kiloliters of kerosene at JPY 46,000/kl.

Risk/Reward Tradeoff

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

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Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

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Investing in Growth Stocks using LEAPS® options

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Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

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. ]

Dividend Capture using Covered Calls

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. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

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What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

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Hedging Against Rising Crude Oil Prices using Crude Oil Futures

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

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

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

Crude Oil Futures Long Hedge Example

An oil refinery will need to procure 100,000 barrels of crude oil in 3 months’ time. The prevailing 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 hedge against a rise in crude oil price, the oil refinery decided to lock in a future purchase price of USD 44.00/barrel by taking a long position in an appropriate number of NYMEX Brent Crude Oil futures contracts. With each NYMEX Brent Crude Oil futures contract covering 1000 barrels of crude oil, the oil refinery 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 oil refinery will be able to purchase 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 Rose by 10% to USD 48.62/barrel on Delivery Date

With the increase in crude oil price to USD 48.62/barrel, the oil refinery will now have to pay USD 4,862,000 for the 100,000 barrels of crude oil. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the crude oil futures price will have converged with the crude oil spot price and will be equal to USD 48.62/barrel. As the long futures position was entered at a lower price of USD 44.00/barrel, it will have gained 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 gain from the long futures position is USD 462,000.

In the end, the higher purchase price is offset by the gain in the crude oil futures market, resulting in a net payment amount of USD 4,862,000 – USD 462,000 = USD 4,400,000. This amount is equivalent to the amount payable when buying the 100,000 barrels of crude oil at USD 44.00/barrel.

Scenario #2: Crude Oil Spot Price Fell by 10% to USD 39.78/barrel on Delivery Date

With the spot price having fallen to USD 39.78/barrel, the oil refinery will only need to pay USD 3,978,000 for the crude oil. However, the loss in the futures market will offset any savings made.

Again, 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 long futures position was entered at USD 44.00/barrel, it will have lost USD 44.00 – USD 39.78 = USD 4.2200 per barrel. With 100 contracts covering a total of 100,000 barrels, the total loss from the long futures position is USD 422,000

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the crude oil futures market and the net amount payable will be USD 3,978,000 + USD 422,000 = USD 4,400,000. Once again, this amount is equivalent to buying 100,000 barrels of crude oil at USD 44.00/barrel.

Risk/Reward Tradeoff

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

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

Learn More About Crude Oil Futures & Options Trading

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Continue Reading.

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

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. ]

Dividend Capture using Covered Calls

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. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

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