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Commodity Hedging - Hedging Risk with a Commodity Futures Hedging Strategy

Commodity hedging and hedging risk with a commodity hedging strategy will give you a quick and dirty tutorial on how and why to use a basic commodity hedge as an insurance policy against risk associated with price fluctuations.

First, Check This Box if you ever saw the movie Trading Places with Eddie Murphy and Dan Akroyd and read on...

Many people who see that movie don't have a clue as to the mass hysteria in the scene on the floor of the Commodity Exchange towards the end of the movie. *By the way, the people on the floor of the Exchange volunteered their time to come in on a Saturday to do the filming.* Anyway…

Randolph and Mortimer, the commodity tycoons that tried to profit from inside information on a pending crop report; took a financial beating as speculators because they were on the wrong side of a huge price move. They risked the farm and lost it. There's an old saying in the industry, "Bulls make money and bears make money, but pigs get killed" Randy and Mort were the "pigs" that day.

Of course the movie was fictional, in reality, if the events were factual, a funny thing would have happened on the way to the farm. The piggies would have lost their roast beef, while the producers and suppliers would have barely batted an eye over the wild price swings….Why?

Because the producers or growers, *the future sellers of orange juice* and suppliers or processors, *the future buyers of orange juice* were using a commodity hedging strategy as an insurance policy against price risks.

Commodity Futures Fact: A futures contract is a Binding Obligation between two parties involving the delivery of a specific quantity and quality of a commodity at a predetermined time and place in the future.

Basic Commodity Hedging Strategy

I want to keep this as simple as possible. First, we are going to stick with the theme of this tutorial and use frozen concentrated orange juice, aka OJ, as our commodity example. We need to know a few things about this commodity before we start. Here's the *specs* for orange juice futures contracts.

Contract Size: 15,000 lbs of orange juice
Point Value: $1.50 per point
Minimum price move: 5 points or 5/100ths of a cent *$7.50 per contract*

We'll assume we are talking about an orange juice producer first. This guy has to sell his orange juice in six months. The problem is that any price drop in the orange juice market would have a negative effect on what he can get for his crop once it's harvested.

He can get around a large part of that risk by establishing a basic short commodity hedging strategy in the orange juice futures market. This gives him some protection, sort of like an insurance policy against large price fluctuations.

How to Put on a Short Hedge in Commodity Futures

Let's say the current price for orange juice in the cash market on May 1st is 90 cents per pound *fictional.* The OJ grower feels that's a fair price to cover his costs and make a profit. He also knows that he will have about 15,000 pounds of OJ to bring to the market at harvest in six months. What he does is sell his crop now using the futures market to protect that 90 cent sale price in the future.

He goes into the futures market and sells 1 contract *15,000 lbs of OJ* at the current market price of $1 per pound. Now lets fast forward 1 month into the future and see how this protects his profit margins.

On June 1st the futures price of OJ had dropped to 70 cents per pound and the cash or current price for OJ drops to 65 cents per pound because there looks to be a bumper crop of OJ this year.

Yipes…doesn't look good as The OJ producer needed to get 90 cents a pound to cover his costs and make a profit. Looks like he won't be buying his kid the GI Joe with the "Kung Fu" grip because he'll be getting $3750 less for his OJ crop.

The decimal point has been omitted and the calculation looks like this: 9000 - 6500 = 2500 X 1.50 = $3750 loss per contract. But wait…

What about the OJ contract he sold in the futures market? Remember he sold 1 contract at $1 per pound? If he were to buy that contract back right now he would only have to pay 70 cents a pound. He has a profit of $4500 for the futures contract.

The decimal point has been omitted and the calculation looks like this 10000 - 7000 = 3000 X 1.50 = $4500 profit per contract.

Now let's analyze what the hedge has done to partially protect the OJ grower's price risk. The $3750 cash loss is offset by the $4500 profit in the futures market, leaving him with a theoretical profit on the hedging strategy of $750. Not a bad deal.

Commodity Futures Fact: A commodity hedging strategy does not remove all price risks. In fact, there are costs associated with trading in commodity futures markets that must be factored into any hedging strategy. Those costs include the commissions paid on the futures trades and the costs associated with placing money in the futures account to cover initial margin requirements (good faith deposits) and maintenance margin calls (additional deposits to cover adverse price variations).

Note that the cash price and the futures price didn't fluctuate in tandem. The reason is that the cash price is influenced by factors such as storage and transportation costs. They will most likely, but not always follow the same trend higher or lower, but rarely at the same rate.

Let's go another month into the future. On July 1st another report shows that the first report overestimated the OJ supply and the price has risen to $1.20 a pound and the cash price of OJ has gone up to $1.05 because of the simple economics of supply and demand.

Yippee…..Happy days…The grower can now get $2250 more for his for his OJ. The calculation looks like this: 10500 - 9000 = 1500 X $1.50 = $2250 more profit…but hold the phone. He shouldn't run out and buy his wife that new BMW he promised her just yet. Let's see what happened with the futures contract hedge.

It will cost him $1.20 per pound to buy back the futures contract he sold at $1. That gives him a loss of $3000 for his futures hedge. The calculation looks like this: 10000 - 12000 = 2000 X $1.50 = $3000 loss.

Now let's see how the commodity futures hedge has limited his potential profit margin. The $2250 gain on the cash price of the OJ crop is offset by the $3000 loss he currently has on his commodity futures hedge. The net result of liquidating the hedge right now would be a loss of $750.

This example shows the importance of maintaining the hedge (regardless of price fluctuations) until the crop is ready for delivery. The cash price and the futures price will converge and become almost equal at the expiration month of the futures contract except for costs such as carrying charges (also known as "the basis").

By liquidating the futures contract and breaking the protection of the hedge before expiration, the grower then becomes at risk to price fluctuations. He also loses money on the costs associated with the futures portion of the hedge itself.

Commodity Futures Fact: In a liquid market, the number of speculators (people looking to profit from price fluctuations) far outnumbers the number of hedgers (those protecting themselves against price risks), but the hedgers generally carry much larger open positions.

How to Put on a Long Hedge in Commodity Futures

The counterpart to the grower and producer is the supplier or processor. In our example here, the processor will need to buy OJ and process it for consumption or other uses. Since the processor must make a future purchase, she wants to protect herself from price increases at the time of delivery.

She will use the futures market as an insurance policy against price risk by putting on a "Long Hedge" in the futures market by buying futures now, thus locking in her price plus the cost of placing the long hedge in commodity futures.

We can look at the price variations and how they affect the processor by simply inverting all the figures from our short hedge example. A rise in the futures price would be a gain for the processor while a fall in the futures price would be a loss.

A rise in the cash price would be a loss to the processor while a fall in the cash price would equal a gain. The risk of future price increases is transferred to the futures market because of the hedge.

There you have it. A basic commodity hedging strategy and how producers and suppliers use the futures markets to protect price variations and profits. This strategy is used in all commodity markets from financials to livestock, agricultural products and even precious metals.

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By: Rick Contrata

Rick has been in the commodity industry for almost 25 years, holding management and executive positions In commodity operations and margins with ACLI, Bear Stearns and DLJ. He also owns an Internet marketing, consulting and copywriting business.

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(914) 381-1981

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