Series to focus on the fundamentals of
energy risk management
This is the first in a series of articles on energy risk management. These articles will cover the fundamentals of futures, options, swaps, basis and spreads. Each of these tools will be analyzed as to how they can be used to protect various areas of risk. We will focus on gasoline and diesel fuel/heating oil and approach this process from three perspectives:
• Risk of margin decline during periods of price increases.
• Risk of loss of inventory value during periods of price decreases.
• Risk of higher prices raising prices on anticipated purchases.
• Contracts that can be offered for sale.
• Buying on forward contracts.
• Buying basis contracts.
Due to the various experience levels of the readers of this series, they will be written from the standpoint of the reader having little or no experience with hedging and the various tools that are used in implementing the hedges.
Before you can learn how to hedge, you must first learn the fundamentals of the tools that will be used in hedging. A wise man once said, “It is best to begin at the beginning” and so we shall begin this series with the basics of futures.
The first futures contract in the United States began in 1865 at the Chicago Board of Trade with the establishment of a futures contract on corn. The New York Mercantile Exchange launched its first energy futures contract with heating oil in 1978 and gasoline futures were introduced in 1984.
First, we need to make the distinction between a physical forward contract and a futures contract.
A forward contract for physical fuel is a contract between two parties for the purchase (or sale) of the actual physical commodity for delivery at a specified location during a specific time frame with the price and quantity determined at the time the contract is entered into.
Example: On Dec. 15, you buy 210,000 gallons of low-sulfur diesel fuel at a price of $1.36 per gallon for delivery in April at the rack in Pittsburgh. Payment is usually the customary terms, such as net 10 days after delivery is taken in April.
Some marketers incorrectly refer to a forward contract as a futures contract. This errant terminology usage tends to muddy the water for customers with little experience in futures markets and contracting.
A wholesaler might wish to purchase a forward contract on physical fuel to offset a sale made to a customer for delivery in the future. If this is the case there are no further transactions necessary because both the purchase and sale have been made; all that is left is for delivery to be made.
A forward contract might also be purchased because the purchaser thought that basis will improve. We will discuss basis in an upcoming article, but understand that the purchase of a forward contract that has not been sold in the physical market is a speculative move, UNLESS it is hedged.
A futures contract is a commitment to make or take delivery of a specific quantity of a given commodity at a predetermined place and time in the future. All terms of the contract are standardized and established in advance except for the price, which is determined by open outcry trading in the pit on the trading floor of an exchange (by computer matching of trades in some instances) and backed by a clearing corporation.
If you are the buyer of one contract of July Heating Oil in New York Harbor during the month of July and have agreed that you will pay $1.25 per gallon for the heating oil, you will pay that price regardless of whether the prices have risen or fallen. One of the unique features of futures is its liquidity. At any point, up to the last trading day for the contract, you can liquidate this contract by simply taking an offsetting position, i.e. you would sell one contract of July Heating Oil futures. Executing the order to take this opposite transaction liquidates the need for physical delivery to occur. More than 99 percent of all the contracts traded on the NYMEX are settled by the taking of offsetting positions rather that through actual physical delivery.
The following is the transactional flow of a futures order from customer through execution and reporting:
- The customer calls a licensed account executive and places an order (sell one contract of July Heating Oil futures “at-the-market.”)
- The broker writes the order and calls the NYMEX floor and relays the order to a phone clerk.
- The phone clerk hands the order into the proper pit to a broker for execution.
- The pit broker executes the order by selling one July Heating Oil futures at the then-current market price of $1.25.
- The pit broker relays the information of the sale back to the phone clerk.
- The executing pit broker has one minute to record all the particulars of the transaction on a trading card (commodity, quantity, month, price, purchasing broker, etc.) and toss the trading card into the center of the pit for data entry.
- The phone clerk at the NYMEX calls the account executive and reports that the trade has been executed and the price that it was filled at.
- The account executive can then report to the customer that he sold one contract of July Heating Oil futures at a price of $1.25 per gallon.
If you were to purchase 42,000 gallons of physical heating oil at $1.25 per gallon, you would have to invest $52,500 in the purchase. If the price of the physical fuel goes 10 cents higher to $1.35 you would have a profit of $4,200. If the price of the physical fuel goes 10 cents lower to $1.15 you would have a loss of $4,200.
Leverage is one of the key components of the futures markets. A purchase of 42,000 gallons of heating oil futures at $1.25 per gallon requires the deposit of an “initial margin.” This amount is set by the exchange and for this example we will assume that it is $4,000 per contract. This is simply good faith money that will be returned if you meet all of your contractual obligations. If the market goes 10 cents higher, your futures purchase is gaining in value and can be sold with a $4,200 gain, exactly what the purchaser of physical fuel would make on a 10-cent gain. If the futures market goes 10 cents lower, as the purchaser you must add $4,200 to your initial deposit (the exact amount of the loss), so that the required excess margin remains in your account.
Many people have the misunderstanding that hedging is trading (speculating) in the futures markets to make money. Nothing could be further from the truth.
Speculation is the attempt to make a profit by taking a position in a market. This can be speculation in the physical fuels as well as speculation in the futures markets.
The job of a hedge is not to speculate in the market, but to attempt to eliminate risk. The textbook definition of a hedge is an equal-and-opposite transaction. Consider the analogy of betting on the Super Bowl; if you bet on one team to win, you have taken a speculative position, you are attempting to make a profit by taking a position. If you bet on both teams to win you are a hedger, you have taken a position to eliminate your risk. When applying this analogy to your operation, you must do so from the standpoint that you have already bet on one team, i.e. if you have taken a long (purchased) position in physical fuel. The job of a hedge is to eliminate the risk of losing money on this inventory due to price declines.
In a true hedge utilizing the futures markets, you must first assess your risk. In doing this you must ask yourself, based on my position in the market, which direction does the market need to go for my physical position to lose money? Then, you must take a position in the futures market that makes money when the market moves that direction.
1. You own physical fuel (this includes purchasing forward contracts) in which case you have a risk of prices going lower. To offset this risk you sell futures.
2. You have sold a forward contract to a customer. To offset this risk you would buy futures.
3. You have a trucking company and have a risk that higher diesel prices will destroy your profit margins. To offset this risk you would buy futures.
In each of these examples one side wins and the other side loses; you have eliminated the risk.
This has been a brief explanation of a futures contract, how it works and some of the basic uses for futures in hedging. Next month, we will discuss swap contracts.
James M. Burr is the vice president of FCStone. You can reach him at (816) 457-6217.