How does hedging in crude oil by an oil and gas company

take place?

Hedging is done by the various risk derivatives. To understand this, it is important to first
understand the basics of risk derivatives.

Broadly there are two types of risk derivatives. Exchange traded and over the counter
derivatives.

As the name suggests, exchange traded derivatives are traded in the international
exchanges (for example New York Mercantile exchange, NYMEX), where standard
contracts, terms of which have been defined by the exchange are traded.
Over the counter (OTC) derivatives are traded through dealers and the contracts are tailor
made. OTC derivatives come with the risk of other party not fulfilling his obligations.

In the trade exchange, future contracts and Options contract derivative are normally traded
and Oil/gas companies choose these two hedging contracts.

To understand these hedging techniques, assume that I am oil/gas Production Company

and I am producing 100000 barrels in a month. Today’s (11th Nov 2014) crude oil price is
$80/barrel. I am afraid that by next month (11th Dec 2014), when I will have inventory of
around 100000 barrels, the crude oil price may fall to below $75/Barrel, and I might make a
loss of $500000 compared with today’s crude oil price. Lets see how I can use hedging to
reduce this loss.

1. Future and Forward contracts:

(The fundamental difference between future and forward contracts is that one is traded in
exchanges while other is traded OTC, here I will discuss Future contracts).
“Future contracts between two parties A & B is a contract where party B has the obligation
to deliver a commodity on agreed date and party A has the obligation to pay on same date
the price, which is agreed today”.

So in my case I am party B and in a future contract with A today, I agree to deliver 100000
barrels of crude oil on 11th Dec 2014 and party A agrees to pay the listed price for Dec 2014
in the trade exchange (say NYMEX). Let us assumed the listed price for Dec 2014 is
$81/Barrel. It is important to note that I do not have to actually (physically) deliver the
crude oil to party A.
Now in Dec 2014 when I have produced 100000 barrels of crude oil. Lets consider two
scenarios

Scenario 1: Crude price drops to $75/barrels as expected by me.

In the Physical market

I sell 100000 barrels of crude oil @ $75/barrel to get $7500000 where as I had expected
$8000000 so I incur loss of $500000 in the physical market.

In the Future contract

My obligation is to deliver 100000 barrels of crude oil which in dec 2014 will cost me
$7500000 @ $75/barrel. But party A has the obligation to pay me @$81/barrel so total of
$8100000. This way in the future contract I make profit of $600000.
Net profit I make is $600000 (Future contract) - $500000 (Physical market) = $100000

So I have hedged the crude oil price with future contract.

Scenario 2: Crude price increase to $82/barrels.

In the Physical market

I sell 100000 barrels of crude oil @ $82/barrel to get $8200000 where as I had expected
$8000000 so I have profit of $200000 in the physical market.

In the Future contract

My obligation is to deliver 100000 barrels of crude oil which in Dec 2014 will cost me
$8200000 @ $82/barrel. But party A has the obligation to pay me @$81/barrel so total of
$8100000. This way in the future contract I make loss of $100000.
Net profit I make is $200000 (Physical market) - $100000 (Future contract) = $100000

So in both case of crude oil price reducing or increasing, I have made more money than I
had expected in Nov 2014. With different number, it might also show some loss, even with
future contract but the loss will be much lesser than what would have been incurred without
hedging.

2. Hedging by OPTIONS Contract

There are two types of options contracts. Call & Put.

The relevant contract for me as Oil/gas production company will be PUT options.

"When I buy PUT options contract from another party (say party A), I have the option to sell
my commodity (crude oil in this case) to party A at a particular price but I am not obliged to
do so. It is upto me, if I want to exercise my option to sell my commodity to party A. My this
right has an expiry date and I can use my option on any date before the expiry".

Off course I will only exercise my option if the price of the crude oil has decreased and not if
the price of crude oil has increased. However to buy this right (option contract) I have to pay
a premium to party A.

Let us assume that I buy "Put option contract" from party A at lock in price of $80/Barrel
for crude oil. Table above shows, how after using “Hedging by Options contract”, I do not
incur any loss even when the price of crude oil has fallen from $80 to $70.

Edit 1: In the example of option contract, the call option can be bought by party A from
Party B (Oil production company).

When party A buys Call option contract from party B, Party A would have option to buy the
commodity from party B at a particular agreed price, but party A is not under any obligation
to do so. It is upto party A, if he wants to exercise his option of buying commodity.