Buying (Going Long) Kerosene Futures to Profit from a Rise in Kerosene Prices

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Contents

Hedging Against Rising Kerosene Prices using Kerosene Futures

Businesses that need to buy significant quantities of kerosene can hedge against rising kerosene price by taking up a position in the kerosene futures market.

These companies can employ what is known as a long hedge to secure a purchase price for a supply of kerosene that they will require sometime in the future.

To implement the long hedge, enough kerosene futures are to be purchased to cover the quantity of kerosene required by the business operator.

Kerosene Futures Long Hedge Example

A kerosene distributor will need to procure 5,000 kiloliters of kerosene in 3 months’ time. The prevailing spot price for kerosene is JPY 45,710/kl while the price of kerosene futures for delivery in 3 months’ time is JPY 46,000/kl. To hedge against a rise in kerosene price, the kerosene distributor decided to lock in a future purchase price of JPY 46,000/kl by taking a long position in an appropriate number of TOCOM Kerosene futures contracts. With each TOCOM Kerosene futures contract covering 50 kiloliters of kerosene, the kerosene distributor will be required to go long 100 futures contracts to implement the hedge.

The effect of putting in place the hedge should guarantee that the kerosene distributor will be able to purchase the 5,000 kiloliters of kerosene at JPY 46,000/kl for a total amount of JPY 230,000,000. Let’s see how this is achieved by looking at scenarios in which the price of kerosene makes a significant move either upwards or downwards by delivery date.

Scenario #1: Kerosene Spot Price Rose by 10% to JPY 50,281/kl on Delivery Date

With the increase in kerosene price to JPY 50,281/kl, the kerosene distributor will now have to pay JPY 251,405,000 for the 5,000 kiloliters of kerosene. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the kerosene futures price will have converged with the kerosene spot price and will be equal to JPY 50,281/kl. As the long futures position was entered at a lower price of JPY 46,000/kl, it will have gained JPY 50,281 – JPY 46,000 = JPY 4,281 per kiloliter. With 100 contracts covering a total of 5,000 kiloliters of kerosene, the total gain from the long futures position is JPY 21,405,000.

In the end, the higher purchase price is offset by the gain in the kerosene futures market, resulting in a net payment amount of JPY 251,405,000 – JPY 21,405,000 = JPY 230,000,000. This amount is equivalent to the amount payable when buying the 5,000 kiloliters of kerosene at JPY 46,000/kl.

Scenario #2: Kerosene Spot Price Fell by 10% to JPY 41,139/kl on Delivery Date

With the spot price having fallen to JPY 41,139/kl, the kerosene distributor will only need to pay JPY 205,695,000 for the kerosene. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the kerosene futures price will have converged with the kerosene spot price and will be equal to JPY 41,139/kl. As the long futures position was entered at JPY 46,000/kl, it will have lost JPY 46,000 – JPY 41,139 = JPY 4,861 per kiloliter. With 100 contracts covering a total of 5,000 kiloliters, the total loss from the long futures position is JPY 24,305,000

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the kerosene futures market and the net amount payable will be JPY 205,695,000 + JPY 24,305,000 = JPY 230,000,000. Once again, this amount is equivalent to buying 5,000 kiloliters of kerosene at JPY 46,000/kl.

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Risk/Reward Tradeoff

As you can see from the above examples, the downside of the long hedge is that the kerosene buyer would have been better off without the hedge if the price of the commodity fell.

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Buying (Going Long) Heating Oil Futures to Profit from a Rise in Heating Oil Prices

If you are bullish on heating oil, you can profit from a rise in heating oil price by taking up a long position in the heating oil futures market. You can do so by buying (going long) one or more heating oil futures contracts at a futures exchange.

Example: Long Heating Oil Futures Trade

You decide to go long one near-month NYMEX Heating Oil Futures contract at the price of USD 1.4777 per gallon. Since each NYMEX Heating Oil Futures contract represents 42000 gallons of heating oil, the value of the futures contract is USD 62,063. However, instead of paying the full value of the contract, you will only be required to deposit an initial margin of USD 10,125 to open the long futures position.

Assuming that a week later, the price of heating oil rises and correspondingly, the price of heating oil futures jumps to USD 1.6255 per gallon. Each contract is now worth USD 68,270. So by selling your futures contract now, you can exit your long position in heating oil futures with a profit of USD 6,206.

Long Heating Oil Futures Strategy: Buy LOW, Sell HIGH
BUY 42000 gallons of heating oil at USD 1.4777/gal USD 62,063
SELL 42000 gallons of heating oil at USD 1.6255/gal USD 68,270
Profit USD 6,206
Investment (Initial Margin) USD 10,125
Return on Investment 61.2972%

Margin Requirements & Leverage

In the examples shown above, although heating oil prices have moved by only 10%, the ROI generated is 61.2972%. This leverage is made possible by the relatively low margin (approximately 16.3140%) required to control a large amount of heating oil represented by each contract.

Leverage is a double edged weapon. The above examples only depict positive scenarios whereby the market is favorable towards you. If the market turn against you, you will be required to top up your account to meet the margin requirements in order for your futures position to remain open.

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Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

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Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

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Valuing Common Stock using Discounted Cash Flow Analysis

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What Determines Oil Prices?

With each passing year, oil seems to play an even greater role in the global economy. In the early days, finding oil during a drill was considered somewhat of a nuisance as the intended treasures were normally water or salt. It wasn’t until 1847 that the first commercial oil well was drilled in Azerbaijan.   The U.S. petroleum industry was born 12 years later with an intentional drilling in Titusville, Pa. 

While much of the early demand for oil was for kerosene and oil lamps, it wasn’t until 1901 that the first commercial well capable of mass production was drilled at a site known as Spindletop in southeastern Texas. This site produced more than 100,000 barrels of oil in one day, more than all the other oil-producing wells in the United States combined.   Many would argue that the modern oil era was born that day in 1901, as oil was soon to replace coal as the world’s primary fuel source. 

Oil’s use in fuels continues to be the primary factor in making it a high-demand commodity around the globe, but how are prices determined?

Key Takeaways

  • Like most commodities, the fundamental driver of oil’s price is supply and demand in the market.
  • Oil markets are composed of speculators who are betting on price moves, and hedgers who are limiting risk in the production or consumption of oil.
  • Oil supply is controlled somewhat by a cartel of oil producing nations called OPEC.
  • Oil demand is driven by everything for gasoline for cars and airline travel to electrical generation.

What Drives Oil Prices?

The Determinants of Oil Prices

With oil’s stature as a high-demand global commodity comes the possibility that major fluctuations in price can have a significant economic impact. The two primary factors that impact the price of oil are:

The concept of supply and demand is fairly straightforward. As demand increases (or supply decreases) the price should go up. As demand decreases (or supply increases) the price should go down. Sounds simple?

Not quite. The price of oil as we know it is actually set in the oil futures market. An oil futures contract is a binding agreement that gives one the right to purchase oil by the barrel at a predefined price on a predefined date in the future. Under a futures contract, both the buyer and the seller are obligated to fulfill their side of the transaction on the specified date.

The following are two types of futures traders:

An example of a hedger would be an airline buying oil futures to guard against potential rising prices. An example of a speculator would be someone who is just guessing the price direction and has no intention of actually buying the product. According to the Chicago Mercantile Exchange (CME), the majority of futures trading done by speculators whereby the purchaser of a futures contract takes possession of the commodity is less than 3%. 

The other key factor in determining oil prices is sentiment. The mere belief that oil demand will increase dramatically at some point in the future can result in a dramatic increase in oil prices in the present, as speculators and hedgers alike snap up oil futures contracts. Of course, the opposite is also true. The mere belief that oil demand will decrease at some point in the future can result in a dramatic decrease in prices in the present as oil futures contracts are sold (possibly sold short as well), which means that prices can hinge on little more than market psychology at times. 

When Economics of Oil Prices Don’t Add Up

Basic supply and demand theory states that the more of a product is produced, the more cheaply it should sell, all things being equal. It’s a symbiotic dance. The reason more was produced in the first place is because it became more economically efficient (or no less economically efficient) to do so. If someone were to invent a well stimulation technique that could double an oil field’s output for only a small incremental cost, then with demand staying static, prices should fall.

Actually, supply has increased. Oil production in North America is at an all-time zenith, with fields in North Dakota and Alberta as fruitful as ever.     Since the internal combustion engine still predominates on our roads, and demand hasn’t kept up with supply, shouldn’t gas be selling for nickels a gallon?

This is where theory butts up against practice. Production is high, but distribution and refinement aren’t keeping up with it. The United States builds an average of one refinery per decade, construction having slowed to a trickle since the 1970s. There’s actually a net loss: the United States has two fewer refineries than it did in 2009.     Still, the 135 remaining refineries in the country have more capacity than any other nation’s by a large margin. The reason we’re not awash in cheap oil is because those refineries operate at 90% of capacity.   Ask a refiner, and they’ll tell you that excess capacity is there to meet future demand.

Commodity Price Cycle Affecting Oil Prices

Additionally, from a historical perspective, there appears to be a possible 29-year (plus or minus one or two years) cycle that governs the behavior of commodity prices in general. Since the beginning of oil’s rise as a high-demand commodity in the early 1900s, major peaks in the commodities index have occurred in 1920, 1958, and 1980. Oil peaked with the commodities index in both 1920 and 1980. (Note: there was no real peak in oil in 1958 because it had been moving in a sideways trend since 1948 and continued to do so through 1968.)   It is important to note that supply, demand, and sentiment take precedence over cycles because cycles are just guidelines, not rules.

Market Forces Impacting Oil Prices

Then there’s the problem of cartels. Probably the single biggest influencer of oil prices is OPEC, made up of 15 countries (Algeria, Angola, Ecuador, Equatorial Guinea, Gabon, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Republic of Congo, Saudi Arabia, United Arab Emirates, and Venezuela); collectively, OPEC controls 40% of the world’s supply of oil. 

Although the organization’s charter doesn’t explicitly state this, OPEC was founded in the 1960s to—put it crudely—fix oil and gas prices. By restricting production, OPEC could force prices to rise, and thereby theoretically enjoy greater profits than if its member countries had each sold on the world market at the going rate. Throughout the 1970s and much of the 1980s, it followed this sound, if somewhat unethical, strategy.   

To quote P. J. O’Rourke, certain people enter cartels because of greed; then, because of greed, they try to get out of the cartels.   According to the U.S. Energy Information Administration, OPEC member countries often exceed their quotas, selling a few million extra barrels knowing that enforcers can’t really stop them from doing so.   With Canada, China, Russia and the United States as non-members—and increasing their own output—OPEC is becoming limited in its ability to, as its mission euphemistically states, “ensure the stabilization of oil markets in order to secure an efficient, economic and regular supply of petroleum to consumers.” 

While the consortium has vowed to keep the price of oil above $100 a barrel for the foreseeable future, in mid-2020, it refused to cut oil production, even as prices began to tumble. As a result, the cost of crude fell from a peak of above $100 a barrel to below $50 a barrel. As of March 2020, oil prices are hovering slightly below $24. 

The Bottom Line

Unlike most products, oil prices are not determined entirely by supply, demand and market sentiment toward the physical product. Rather, supply, demand and sentiment toward oil futures contracts, which are traded heavily by speculators, play a dominant role in price determination. Cyclical trends in the commodities market may also play a role. Regardless of how the price is ultimately determined, based on its use in fuels and countless consumer goods, it appears that oil will continue to be in high demand for the foreseeable future.

4 Ways Airlines Hedge Against Oil

The largest operating cost center for airlines, on average, are the companies’ fuel expenses and those expenses related to the procurement of oil.

When oil prices are increasing in the global economy, it’s natural that the stock prices of airlines drop. When oil prices decline in the economy, it’s equally natural that the stock prices of airlines go up. Fuel costs are such a large part of an airline’s overhead percentage-wise that the fluctuating price of oil greatly affects the airline’s bottom line.

To protect themselves from volatile oil costs, and sometimes to even take advantage of the situation, airlines commonly practice fuel hedging. They do this by buying or selling the expected future price of oil through a range of investment products, protecting the airline companies against rising prices.

Purchasing Current Oil Contracts

In this hedging scenario, an airline would have to believe that prices will rise in the future. To mitigate these rising prices, the airline purchases large amounts of current oil contracts for its future needs.

This is similar to a person who knows that the price of gas will increase over the next 12 months and that he will need 100 gallons of gas for his car over the next 12 months. Instead of buying gas as needed, he decides to purchase all 100 gallons at the current price, which he expects to be lower than the gas prices in the future.

Purchasing Call Options

When a company purchases a call option, it allows the company to purchase a stock or commodity at a specific price within a certain date range. This means that airline companies are able to hedge against rising fuel prices by buying the right to purchase oil in the future at a price that is agreed on today.

For example, if the current price per barrel is $100, but an airline company believes that the prices will increase, that airline company can purchase a call option for $5 that gives it the right to purchase a barrel of oil for $110 within a 120-day period. If the price per barrel of oil increases to above $115 within 120 days, the airline will end up saving money.

Implementing a Collar Hedge

Similar to a call option strategy, airlines can also implement a collar hedge, which requires a company to purchase both a call option and a put option. Where a call option allows an investor to purchase a stock or commodity at a future date for a price that’s agreed upon today, a put option allows an investor to do the opposite: sell a stock or commodity at a future date for a price that’s agreed on today.

A collar hedge uses a put option to protect an airline from a decline in the price of oil if that airline expects oil prices to increase. In the example above, if fuel prices increase, the airline would lose $5 per call option contract. A collar hedge protects the airline against this loss.

Purchasing Swap Contracts

Finally, an airline can implement a swap strategy to hedge against the potential of rising fuel costs. A swap is similar to a call option, but with more stringent guidelines. While a call option gives an airline the right to purchase oil in the future at a certain price, it doesn’t require the company to do so.

A swap, on the other hand, locks in the purchase of oil at a future price at a specified date. If fuel prices decline instead, the airline company has the potential to lose much more than it would with a call option strategy.

Buying (Going Long) Kerosene Futures to Profit from a Rise in Kerosene Prices

Given the significant volatility in fuel prices in recent weeks, we’ve been fielding numerous inquiries from companies who are interested in developing a fuel hedging program for the first time in their company’s history. If you lack the knowledge to consider yourself a fuel hedging expert, this post along with several more that we’ll be publishing shortly, will help you better obtain a better understanding of most common fuel hedging strategies available to commercial and industrial fuel consumers.

For starters, what is a futures contract? A futures contract is simply a standardized contract, between two parties to buy or sell a specific quantity and quality of a commodity for a price agreed upon at the time the transaction takes place, with delivery and payment occurring at a specified future date. The contracts are negotiated on a futures exchange, such as CME/NYMEX or ICE, which acts as a neutral intermediary between the buyer and seller. The party agreeing to buy the futures contract, the “buyer”, is said to be “long” the futures while the party agreeing to sell the futures contract, the “seller” of the contract, is said to be “short” the futures.

In essence, a futures contract obligates the buyer of the contract to buy the underlying commodity at the price at which he bought the futures contract. Similarly, a futures contract also obligates the seller of the contract to sell the underlying commodity at the price at which he sold the futures contract. That being said, in practice, very few futures contracts actually result in delivery, as most are utilized for hedging and are bought back or sold back prior to expiration.

There are three primary futures contracts which are commonly used for fuel hedging: ULSD (ultra-low sulfur diesel) and RBOB gasoline, which are traded on CME/NYMEX and gasoil, which is traded on ICE. Regardless of whether you’re looking at hedging bunker fuel, diesel fuel, gasoline, jet fuel or any other refined product, these three contracts serve as the primary benchmarks across the globe. In addition, there are many other contracts (futures, swaps and options) available for fuel hedging, most of which are tied to one of the major, global trading hubs of Singapore, US Gulf Coast (Houston/New Orleans) and NW Europe/ARA (Amsterdam, Rotterdam and Antwerp). As an aside, the CME/NYMEX futures contract was previously known as heating oil and as such still trades under the symbol HO. For more information on the transition from heating oil to ULSD see NYMEX Heating Oil Completes Transition to Ultra Low Sulfur Diesel.

So how can you utilize futures contracts to hedge your exposure to rising fuel prices? Let’s assume that your company owns or leases a large fleet of vehicles and, to ensure that your fuel costs do not exceed your budgeted fuel price, you have been asked to “fix” or “lock in” the price of your anticipated fuel consumption. For sake of simplicity, let’s assume that you are looking to hedge (by “fixing” or “locking” in the price) 42,000 gallons of ULSD (diesel fuel) which you anticipate consuming in August 2020. To accomplish this, you could purchase one September ULSD futures contract, which happens to trade in 42,000 gallon (42,000 gallons = 1,000 barrels) increments. If you had purchased this contract based on the closing price yesterday, you could have hedged your August diesel fuel for $1.8265/gallon (which excludes taxes and basis differentials as well as distribution and transportation fees).

Now let’s theoretically fast forward to August 30, the expiration date of the September ULSD futures contract. Because you do not want to take delivery of 42,000 gallons of ULSD in New York Harbor, the delivery point of the CME/NYMEX ULSD futures contract, you decide to close out your position by “selling back” one September ULSD futures contract at the then, prevailing market price.

In scenario one, let’s assume that the prevailing market price, at which you sold back the futures, was $2.00/gallon. In this scenario, your gain on the futures contract would equate to a profit of $01735/gallon ($2.00-$1.8265=$0.1735). As such, in this scenario your net cost will be $0.1735 less than the price you pay “at the pump” due to your hedging gain.

In scenario two, let’s assume that the prevailing market price, at which you sold back the futures, was $1.75/gallon. In this scenario, your loss on the futures contract would equate to $0.0765/gallon ($1.75-$1.8265=$0.0765). Contrary to the first scenario, in this scenario your net cost will be $0.0765 more than the price you pay “at the pump” due to your hedging loss.

As this example indicates, purchasing a ULSD futures contract provides you with the ability to hedge of fix your anticipated diesel fuel costs for a specific month(s), regardless of whether the price of ULSD futures increase or decreases between the date that you purchased the futures contract and the date the futures contract expires.

While this example focused on hedging diesel fuel with ULSD futures, the same methodology applies to hedging gasoil, gasoline, heating oil, jet fuel, etc.

While there are many details that need to be considered before hedging with futures, the basic methodology of hedging fuel price risk with futures is pretty simple. That is, if you need to hedge your exposure to potentially rising fuel prices you can do so by purchasing a futures contract. Similarly, if you need to hedge your exposure to declining fuel prices, you can do so by selling a futures contract.

Caveat emptor: Most companies will find that hedging their fuel price exposure is less than ideal as futures contracts expire on a specific day of the month and most businesses consume fuel every day. As such, many companies find that swaps (or futures which act as “look-a-likes” to swaps) serve as a better tool as most fuel swaps generally settle against the monthly average price (more on this in an upcoming post).

This article is the first in the series titled A Beginners Guide to Fuel Hedging. The subsequent posts in the series can be found via the following links:

Editor’s Note: The post was originally published in August 2020 and has recently been updated to reflect current market conditions.

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