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The plunge in oil prices has strained the balance sheets of drillers and reduced costs for airlines. One way that companies manage the risks from commodities market swings is through hedging.

So what is hedging exactly?

No silly gardening jokes please. Hedging involves locking in a price to buy or sell a commodity in the future. It is a form of insurance against adverse moves in markets notorious for them. Hedging is also employed in currencies, interest rates and stock indices, but it originated in grain markets.

Who hedges commodities?

Businesses that are exposed to commodity price swings find hedging useful. A farmer worried that corn prices will fall after harvest might lock in a sale price during spring planting. Mexico annually hedges the value of its crude oil exports, paying banks a premium to ensure predictable revenue for its federal budget. Hedging “gives greater freedom for business action”, wrote Holbrook Working, a leading 20th-century economist of commodities markets.

OK, how do companies hedge?

Traditionally with derivatives such as futures and options. Futures contracts have two sides: a “long,” or buyer, and a “short,” or seller. An airline concerned about a future rise in the price of jet fuel might buy oil futures and take a long position. If crude jumps from $60 to $70 a barrel, the corresponding increase in the value of the airline’s futures position will help offset the higher price it will pay fuel suppliers. Conversely, an international oil producer worried that crude will fall from $60 a barrel to $50 might sell, or go short, in oil futures, locking in the sale price at $60.

Who takes the other side of the trade?

Futures markets are anonymous, so anybody from the oil producer to a hedge fund or bank could be the counterparty to the airline’s trade. Despite the name, hedge funds are classic speculators, or traders seeking to make money on price moves rather than insure against them. Commercial companies can also sometimes take speculative positions, meaning data (such as the US Commodity Futures Trading Commission’s “Commitments of Traders” reports) categorising trader positions as commercial or noncommercial should be viewed with care.

Can hedging have an impact on markets?

Big volumes from the execution of a hedging programme can move the price of futures markets and influence the value of options.

Hedges already in place can affect how companies respond to price signals. For example, US oil prices have declined more than 50 per cent since last June.

According to Barclays, US producers have hedged 22 per cent of their 2015 oil output. These hedges help soften the blow from oil’s fall and delay the imperative to cut production. The US government forecasts onshore production will keeping rising until May 2015 despite low prices — a phenomenon partly explained by hedging.

Hmm, if hedges are so handy, why doesn’t every company hedge?

Hedges can be costly. Mexico paid banks $773m for options to hedge its 2015 oil exports at a sale price of $76.40 per barrel. (The deal already appears worthwhile, since Mexico’s oil now fetches less than $50 on the spot market.)

Companies using futures can face hefty margin calls — or demands for more collateral — if the market moves against them. Margin calls prompted by a cotton price increase bankrupted some merchants in 2008.

Investors seeking to play a commodities rebound without becoming futures speculators themselves may also prefer shares of companies that don’t hedge. All things equal, an unhedged driller has more to gain from a rising oil price than one already enmeshed in hedges.

This article is the eighth in an online series on commodities made easy
Click here for other articles in the series, or go to our Flipboard page

Further reading:
Mexico insures against a further oil price fall
Oil price volatility hits European airlines
Cotton’s middlemen pinched by high price
Gold bulls deeply suspicious of hedging

Copyright The Financial Times Limited 2017. All rights reserved.
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