In a debate i need to oppose the topic "Should crude oil purchase be hedged?". I am not very familiar with the trading industry so I would like to know good facts and ideas in order to oppose this topic.
Can you be a little clearer? Are you opposing the idea that crude oil should be hedged? You are supporting that crude purchases should NOT be hedged? Purchases by who? Refineries? We need more information about the context of the debate.
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Suppose you produce a new barrel of oil today, and given the macro-economic environment you might think the price of oil will continue to decline into your physical delivery of that barrel of oil to market. In this scenario it would make some economic sense to hedge your position (lock in your selling price) to today's price in expectation of the price at delivery being significantly lower at the time of delivery. Now multiply that by 90,000 barrels a day of production and you begin to see the real need for the futures market. The futures market is basically a form of price insurance for the producers and consumers of the commodity.
The short answer to your question is: " It depends."
As others have noted, yours is a very open ended question but I will try, and I didnt "grow up" trading so my language is going to be different from a pit trader's and I apologize for that but hopefully I can convey the ideas. I have a background in the fuel products space so most of what I describe is based on gasoline and heating oil commodities.
In general, physical commodities have various types of price risks. Hedging is the act of mitigating some of these risks. Not all risks can or should be hedged. If a position (buy or sell) was perfectly hedged, the position would be considered "flat" and the trader would not stand to gain or lose anything from his position.
Price risk exists because of mainly these reasons for physical commodities:
1) The futures markets (these are commodity futures products traded on CME etc)
2) The basis markets (these are published by organizations like platts, opis, argus and some brokers depending upon the commodity)
3) Correlated commodities/products
Basis markets exist for physical commodities at various physical locations where product is shipped/delivered. These also have a forward curve like futures do but the price points may be different (may not be months). For instance, gasoline futures are traded for each forward month for a number of months into the future but gasoline basis pricing is based on the pipeline shipping the physical product - some pipelines ship 3 times a month and some 6. These are called cycles and each cycle has a basis.
If you are a physical trader and are holding a long position, you are exposed to both futures and basis risk. A long physical position holder may hedge his futures price risk by selling an equivalent number of futures contracts on the exchange thereby leaving him exposed only to basis risk. Or he could use options on futures and achieve the same result. Sometimes a trader will sell the near month futures and buy the back month futures (a calendar spread) if the nearby month is too volatile and is causing large swings in his p&l for instance.
To hedge the entire position, the long position holder can either sell the entire position to a different counterparty. Or he could sell a basis swap in addition to selling futures and become flat technically.
Then there are correlated markets that can be used to hedge a position. WTI crude oil is inversely correlated to the US dollar. Technically, one way of hedging a long WTI crude oil position would be to sell short the US dollar.
A trader would want to hedge (fully or partially) his position if he wants to "lock in" his p&l (fully or partially). He might want to do this either for a short period of time or for the entire duration of the trade and may employ various techniques depending upon the need.
If you want to oppose the idea of hedging a purchase then that means the trader has to be in a position to afford to NOT lock in his p&l. This is why it depends so much upon who that trader is and what his situation is:
1. The number 1 reason for not hedging has to be that no matter who the trader is, he is confident that the price of oil is going to rise and therefore sees no reason to hedge his long position.
2. If the trader is an airliner or a fuel distributor who is long crude oil, he may not want to hedge because he knows he can pass on any adverse changes in price to their retail customers and not incur a loss if price moves against him.
3. If a trader is long oil and believes that the US dollar is going to come under pressure for any number of reasons in the near term, then he may decide to not hedge until that condition exists and he stands to gain on his position
Basically, a trader will not want to hedge if he is confident he stands to gain from having a completely open, unhedged position. I think that has to be your argument.
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This chart shows the current Commitment of Traders separated by category.
What we see here is as the price of crude oil has trended down, producers and commercial spec's are net short, whereas funds and large spec's are net long by an (roughly) equivalent amount of contracts.
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Be Patient and Trade Smart
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This post has been selected as an answer to the original posters question
I'd much rather be arguing the other side - reasons that you should hedge.
A decision not to hedge is (in most cases) a decision to speculate. - Whatever your underlying business is (production, refining, transport etc) a decision not to hedge means that you are at the mercy of the markets, and your business will succeed or fail based upon the market, and not what you and your business do.
Saying that I don't think I've ever met a production company who wants to hedge. They all do hedge, because the banks force them to, but they don't want to. Every production company always thinks CL/NG is going to infinity. I guess it's not really surprising - that's why they are in the business!
Anyway, back on topic - arguments for not hedging. 1) The hedge is a dirty/ineffective hedge and an argument can be made that it does not reduce risk.
This normally ties back into @Hulk 's comments regarding Basis but could be due to other reasons. Rarely can you hedge your risk perfectly - you are nearly always left with something. Even if you produce WTI in Oklahoma and sell CL futures as a hedge - chances are you actually sell your phyiscal crude based upon a posting price, so you still have the spread risk between the posting price and the futures price. Now imagine that your not producing WTI in Oklahoma but some thick sour heavy crude in say Oregon. Now your crude has no similar physical properties to WTI and is geographically in a completely different market (East/West of Rockies). Hence an argument can be made that selling a WTI hedge to hedge your price risk may not help you in anyway. You could end up in the situation that WTI prices rally, meaning you lose money on your hedge, but prices for your yucky Oregon crude don't move up - so your hosed! While that may sound far fetched it has happened many many a time. I believe Apache once (1990's?) hedged their western US Natural Gas production with Henry Hub Futures or Swaps. Unfortunately when prices in the eastern US spiked prices in the west did not move. If I remember correctly Apache lost more on their hedges than their physical natural gas was worth! But then again maybe that was just an 'old wives tale'. Either way good story.
An additional risk to this is that your accountant deems that your hedges are ineffective. I'm not sure what the full implications of this are but it's not good! 2) Hedge related Cash Flow Risk.
Imagine that you have this fantastic oil field that you know is going to produce X barrels of oil over the next 5 years. Since it only costs you $30 to drill the oil and market prices are $50 you decided to hedge and sell futures contracts out for 5 years. Now imagiine that crude does the opposite of what it has done in the last 6 months and doubles to $100/barrel. If your hedges are marginable - and futures most definitely are - you will have to post $50/bbl CASH collateral to support your hedges. Now imagine that your lovely oil field produces say 10,000 bbls/day so you have sold 18 million barrels of hedges against it. You now owe your counterparty/the exchange $912.5 Million and they don't care that your field produces crude @ $30... they want/need the cash. Even if you happen to have a spare Billion lieing around that you can give them, imagine what happens to your stock price when you announce at the end of the quarter that you your cash flow was a Billion worse than analysts expect due to derivative hedge losses. Bye Bye Stock Price.
This was a real problem for production companies over the last few decades. The way this is avoided today is that most production companies transact hedges that are non-marginable. The only way to do this is to hedge with banks that are on your credit revolver - as they just count the exposure against your credit line. Unfortunately you are then at their mercy when it comes to hedge prices - you have nobody else to go to. 3) Operational Risks/Uncertainties making hedging unfeasible.
Sort of self explanatory. If you don't know when your project is coming on line, how quickly it will ramp up, and how much it will produce - it's generally difficult to hedge any/all of it!
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Hi Kurlare, Thank you for your response. Yes i have to oppose the topic. That means i should say that crude oil should not be hedged. I am more focused on a scenario where the government is the sole purchaser of crude oil for a country (Most Asian countries are like that). I know it's tricky to oppose! That is why i need good points, may be examples from past where crude oil hedging went wrong which resulted in bad economic results for a country.
Exactly,it depends. Since in the debate i have to point out that "crude oil should not be hedged" i have to bring forward examples pointing out scenarios where crude oil hedging is not necessary or scenarios where crude oil hedging went wrong.
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