Using Futures to Hedge Commodity Exposure
Using Futures to Hedge Commodity Exposure
Futures contracts enable producers and consumers to lock in commodity prices, converting price uncertainty into known costs or revenues. Airlines hedge jet fuel, farmers hedge crop prices, and manufacturers hedge raw materials—all using exchange-traded futures to manage business risk.
Definition and Key Concepts
Producer vs. Consumer Hedges
| Hedger Type | Exposure | Futures Position | Goal |
|---|---|---|---|
| Producer (farmer, oil company) | Long commodity | Short futures | Lock in sale price |
| Consumer (airline, manufacturer) | Short commodity | Long futures | Lock in purchase price |
Hedge Ratio Fundamentals
Minimum variance hedge ratio: h* = ρ × (σS / σF)
Where:
- h* = optimal hedge ratio
- ρ = correlation between spot and futures
- σS = standard deviation of spot price changes
- σF = standard deviation of futures price changes
For highly correlated contracts: h* ≈ 1.0 (one futures contract per unit of exposure)
Key Terms
| Term | Definition |
|---|---|
| Basis | Spot price minus futures price |
| Convergence | Basis approaching zero at expiry |
| Roll | Closing expiring position, opening new month |
| Cross-hedge | Hedging with related but different commodity |
How It Works in Practice
Short Hedge (Producer)
Situation: Oil producer will sell 100,000 barrels in 3 months.
Hedge execution: Sell 100 WTI crude oil futures (1,000 bbl each)
Outcome scenarios:
| Oil Price | Spot Revenue | Futures P/L | Net Revenue |
|---|---|---|---|
| $70/bbl | $7,000,000 | +$500,000 | $7,500,000 |
| $75/bbl | $7,500,000 | $0 | $7,500,000 |
| $80/bbl | $8,000,000 | -$500,000 | $7,500,000 |
The hedge locks in $75/bbl regardless of price movement.
Long Hedge (Consumer)
Situation: Airline needs 50,000 barrels of jet fuel in 6 months.
Hedge execution: Buy 50 NYMEX heating oil futures (42,000 gal = ~1,000 bbl each) as proxy for jet fuel.
Cross-hedge adjustment: Jet fuel moves with heating oil but not perfectly. Historical correlation: 0.92 Historical volatility ratio: 1.05
Hedge ratio = 0.92 × 1.05 = 0.97
Adjusted contracts: 50 × 0.97 ≈ 48 contracts
Roll Mechanics
Standard roll process:
| Step | Action |
|---|---|
| 1 | Close expiring position before first notice day |
| 2 | Open new position in deferred month |
| 3 | Recognize roll P/L |
Roll cost in contango: If near month = $75 and next month = $76: Roll cost = $1 per barrel
Roll gain in backwardation: If near month = $75 and next month = $73: Roll gain = $2 per barrel
Worked Example
Scenario: Agricultural co-op will harvest 500,000 bushels of corn in October.
Current conditions:
- December corn futures: $5.00/bushel
- Expected harvest basis: -$0.30 (local price below futures)
- Target net price: $4.70/bushel
Hedge setup: Sell 100 corn futures (5,000 bu each) = 500,000 bushels hedged Futures position: Short at $5.00
Outcome 1: Prices fall
- October spot price: $4.20/bushel
- December futures: $4.50/bushel
- Actual basis: -$0.30
| Component | Calculation | Result |
|---|---|---|
| Spot sale | 500,000 × $4.20 | $2,100,000 |
| Futures gain | 500,000 × ($5.00 - $4.50) | +$250,000 |
| Net revenue | $2,350,000 | |
| Net price | $4.70/bushel |
Outcome 2: Prices rise
- October spot price: $5.50/bushel
- December futures: $5.80/bushel
- Actual basis: -$0.30
| Component | Calculation | Result |
|---|---|---|
| Spot sale | 500,000 × $5.50 | $2,750,000 |
| Futures loss | 500,000 × ($5.00 - $5.80) | -$400,000 |
| Net revenue | $2,350,000 | |
| Net price | $4.70/bushel |
In both cases, net price = $4.70 (futures price minus basis).
Basis Risk Impact
Basis widens unexpectedly:
- Expected basis: -$0.30
- Actual basis: -$0.50
| Component | Result |
|---|---|
| Target price | $4.70 |
| Basis surprise | -$0.20 |
| Actual net price | $4.50 |
Basis risk reduced the effective price by $0.20/bushel.
VaR Analysis
Unhedged VaR (95%, 3-month): = 500,000 bu × $5.00 × 20% price volatility × 1.65 = $825,000
Hedged VaR (basis risk only): = 500,000 bu × $0.15 basis volatility × 1.65 = $123,750
VaR reduction: 85%
Risks, Limitations, and Tradeoffs
Basis Risk
| Factor | Impact on Basis |
|---|---|
| Location | Transportation costs vary |
| Quality | Premium/discount to contract spec |
| Timing | Cash vs. futures timing mismatch |
| Supply/demand | Local conditions differ from global |
Quantity Risk
| Scenario | Issue |
|---|---|
| Lower production | Over-hedged; short futures without commodity |
| Higher production | Under-hedged; excess exposure |
Mitigation: Hedge expected production, not maximum possible.
Roll Risk
| Risk | Description |
|---|---|
| Roll cost | Contango erodes returns |
| Liquidity | Deferred months may be illiquid |
| Gap risk | Price jumps between roll trades |
Margin Requirements
Margin considerations:
| Factor | Impact |
|---|---|
| Initial margin | Capital required upfront |
| Variation margin | Daily cash flows |
| Margin calls | Liquidity drain in adverse moves |
Example: 100 WTI futures at $5,000 initial margin each = $500,000 tied up
Common Pitfalls
| Pitfall | Description | Prevention |
|---|---|---|
| Wrong month | Hedging with wrong expiry | Match physical timing |
| Quantity mismatch | Contract size doesn't fit exposure | Calculate carefully |
| Ignoring basis | Assuming perfect hedge | Track basis exposure |
| Margin surprise | Cash flow issues on margin calls | Maintain liquidity buffer |
Cross-Hedging Considerations
When exact futures contract unavailable:
| Physical Exposure | Proxy Futures | Correlation |
|---|---|---|
| Jet fuel | Heating oil | 0.90-0.95 |
| Gasoline (regional) | RBOB | 0.85-0.95 |
| Copper scrap | LME copper | 0.80-0.90 |
| Wheat (soft red) | CBOT wheat | 0.90-0.95 |
Cross-hedge ratio = Correlation × (Physical vol / Futures vol)
Checklist and Next Steps
Hedge design checklist:
- Identify physical exposure quantity
- Select appropriate futures contract
- Calculate hedge ratio
- Choose contract month (match physical timing)
- Estimate basis and basis risk
- Calculate margin requirements
- Plan roll schedule
Execution checklist:
- Verify contract specifications
- Execute futures position
- Post initial margin
- Set up daily settlement monitoring
- Document hedge for accounting
Ongoing management:
- Monitor basis daily/weekly
- Track margin utilization
- Adjust for volume changes
- Execute rolls before expiry
- Calculate hedge effectiveness
Related articles:
- For concentrated stock hedging, see Protecting Concentrated Stock Positions
- For interest rate hedging, see Interest Rate Risk Hedging with Swaps