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This article may be the first in a string in which I will be exploring the most frequent strategies utilized by coal and oil manufacturers to hedge their particular experience of crude oil, natural gas and NGL costs.

Within the power areas you can find six main power futures agreements, four which are exchanged on nyc Mercantile Exchange (NYMEX): WTI crude oil, Henry Hub gas, NY Harbor ultra-low sulfur diesel (previously home heating oil) and RBOB gasoline and two of which are exchanged on IntercontinentalExchange (ICE): Brent crude oil and gasoil.

A futures agreement provides the purchaser associated with the contract, suitable and obligation, to purchase the root product on price from which he purchases the futures contract. Alternatively, a futures agreement gives the seller for the agreement, just the right and responsibility, to market the root commodity during the cost from which he sells the futures contract. However, used, hardly any product futures contracts in fact result in delivery, the majority are used for hedging and offered or bought back just before expiration.

How can an oil and gas producer utilize futures agreements to hedge their particular contact with volatile gas and oil costs? As an example, let`s say you are a crude oil producer who wants to hedge the price of your personal future crude oil production. For sake of ease, let's assume that you will be trying to hedge (by "fixing" or "locking" inside cost) your October crude oil production. To hedge this manufacturing with futures, you can sell (brief) a November crude oil futures contract.

You'd offer the November, rather than the October futures agreement, because the November futures agreement expires during manufacturing thirty days of October. But the November futures agreement will expire through the center of the October manufacturing month so to correctly hedge October production you'll likely utilize a mix of November and December futures agreements. This complexity, referred to as “calendar foundation risk” in trading jargon, is the reason numerous gas and oil producers hedge with swaps without futures. We’ll address calendar foundation threat in more level in another post into the perhaps not too distant future.

In the event that you had sold these futures in line with the finishing price of November WTI crude oil futures yesterday, you'll have hedged your October manufacturing at about $46.93/BBL.


Let's today assume that it is October 20, the conclusion day of this November WTI crude oil futures agreement. Because you do not want to make distribution for the futures contract, you buy back the November futures agreement during the prevailing market price to close out your situation.

Examine just how your method will continue to work if the November crude oil futures contract settles at rates both above and below your price of $46.93, let's examine here two scenarios.

In the first scenario, let's hypothetically say your prevailing selling price, at which you buy back the November WTI crude oil futures contract, is $60/BBL, which can be $13.07/BBL higher than the cost where you marketed the futures contract. Within situation, you'd receive approximately $60/BBL for your October crude oil production. But your net income could be $46.93, the cost of which you originally sold the futures agreement, excluding the basis differential, gathering and transportation costs, etc. This is because you would bear a loss in $13.07/BBL ($60.00 - $46.93 = $13.07) regarding the futures agreement.

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