Hedging Against Rising Natural Gas Prices using Natural Gas Futures

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Contents

Hedging Against Rising Natural Gas Prices using Natural Gas Futures

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

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

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

Natural Gas Futures Long Hedge Example

A power company will need to procure 1.00 million mmbtus of natural gas in 3 months’ time. The prevailing spot price for natural gas is USD 5.5150/mmbtu while the price of natural gas futures for delivery in 3 months’ time is USD 5.5000/mmbtu. To hedge against a rise in natural gas price, the power company decided to lock in a future purchase price of USD 5.5000/mmbtu by taking a long position in an appropriate number of NYMEX Natural Gas futures contracts. With each NYMEX Natural Gas futures contract covering 10000 mmBtus of natural gas, the power company 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 power company will be able to purchase the 1.00 million mmbtus of natural gas at USD 5.5000/mmbtu for a total amount of USD 5,500,000. Let’s see how this is achieved by looking at scenarios in which the price of natural gas makes a significant move either upwards or downwards by delivery date.

Scenario #1: Natural Gas Spot Price Rose by 10% to USD 6.0665/mmbtu on Delivery Date

With the increase in natural gas price to USD 6.0665/mmbtu, the power company will now have to pay USD 6,066,500 for the 1.00 million mmbtus of natural gas. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the natural gas futures price will have converged with the natural gas spot price and will be equal to USD 6.0665/mmbtu. As the long futures position was entered at a lower price of USD 5.5000/mmbtu, it will have gained USD 6.0665 – USD 5.5000 = USD 0.5665 per mmbtu. With 100 contracts covering a total of 1.00 million mmbtus of natural gas, the total gain from the long futures position is USD 566,500.

In the end, the higher purchase price is offset by the gain in the natural gas futures market, resulting in a net payment amount of USD 6,066,500 – USD 566,500 = USD 5,500,000. This amount is equivalent to the amount payable when buying the 1.00 million mmbtus of natural gas at USD 5.5000/mmbtu.

Scenario #2: Natural Gas Spot Price Fell by 10% to USD 4.9635/mmbtu on Delivery Date

With the spot price having fallen to USD 4.9635/mmbtu, the power company will only need to pay USD 4,963,500 for the natural gas. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the natural gas futures price will have converged with the natural gas spot price and will be equal to USD 4.9635/mmbtu. As the long futures position was entered at USD 5.5000/mmbtu, it will have lost USD 5.5000 – USD 4.9635 = USD 0.5365 per mmbtu. With 100 contracts covering a total of 1.00 million mmbtus, the total loss from the long futures position is USD 536,500

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the natural gas futures market and the net amount payable will be USD 4,963,500 + USD 536,500 = USD 5,500,000. Once again, this amount is equivalent to buying 1.00 million mmbtus of natural gas at USD 5.5000/mmbtu.

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Risk/Reward Tradeoff

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

An alternative way of hedging against rising natural gas prices while still be able to benefit from a fall in natural gas price is to buy natural gas call options.

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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. ]

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Hedging Against Falling Natural Gas Prices using Natural Gas Futures

Natural Gas producers can hedge against falling natural gas price by taking up a position in the natural gas futures market.

Natural Gas producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of natural gas that is only ready for sale sometime in the future.

To implement the short hedge, natural gas producers sell (short) enough natural gas futures contracts in the futures market to cover the quantity of natural gas to be produced.

Natural Gas Futures Short Hedge Example

A natural gas producer has just entered into a contract to sell 1.00 million mmbtus of natural gas, to be delivered in 3 months’ time. The sale price is agreed by both parties to be based on the market price of natural gas on the day of delivery. At the time of signing the agreement, spot price for natural gas is USD 5.5150/mmbtu while the price of natural gas futures for delivery in 3 months’ time is USD 5.5000/mmbtu.

To lock in the selling price at USD 5.5000/mmbtu, the natural gas producer can enter a short position in an appropriate number of NYMEX Natural Gas futures contracts. With each NYMEX Natural Gas futures contract covering 10,000 mmBtus of natural gas, the natural gas producer will be required to short 100 futures contracts.

The effect of putting in place the hedge should guarantee that the natural gas producer will be able to sell the 1.00 million mmbtus of natural gas at USD 5.5000/mmbtu for a total amount of USD 5,500,000. Let’s see how this is achieved by looking at scenarios in which the price of natural gas makes a significant move either upwards or downwards by delivery date.

Scenario #1: Natural Gas Spot Price Fell by 10% to USD 4.9635/mmbtu on Delivery Date

As per the sales contract, the natural gas producer will have to sell the natural gas at only USD 4.9635/mmbtu, resulting in a net sales proceeds of USD 4,963,500.

By delivery date, the natural gas futures price will have converged with the natural gas spot price and will be equal to USD 4.9635/mmbtu. As the short futures position was entered at USD 5.5000/mmbtu, it will have gained USD 5.5000 – USD 4.9635 = USD 0.5365 per mmbtu. With 100 contracts covering a total of 1000000 mmbtus, the total gain from the short futures position is USD 536,500

Together, the gain in the natural gas futures market and the amount realised from the sales contract will total USD 536,500 + USD 4,963,500 = USD 5,500,000. This amount is equivalent to selling 1.00 million mmbtus of natural gas at USD 5.5000/mmbtu.

Scenario #2: Natural Gas Spot Price Rose by 10% to USD 6.0665/mmbtu on Delivery Date

With the increase in natural gas price to USD 6.0665/mmbtu, the natural gas producer will be able to sell the 1.00 million mmbtus of natural gas for a higher net sales proceeds of USD 6,066,500.

However, as the short futures position was entered at a lower price of USD 5.5000/mmbtu, it will have lost USD 6.0665 – USD 5.5000 = USD 0.5665 per mmbtu. With 100 contracts covering a total of 1.00 million mmbtus of natural gas, the total loss from the short futures position is USD 566,500.

In the end, the higher sales proceeds is offset by the loss in the natural gas futures market, resulting in a net proceeds of USD 6,066,500 – USD 566,500 = USD 5,500,000. Again, this is the same amount that would be received by selling 1.00 million mmbtus of natural gas at USD 5.5000/mmbtu.

Risk/Reward Tradeoff

As can be seen from the above examples, the downside of the short hedge is that the natural gas seller would have been better off without the hedge if the price of the commodity went up.

An alternative way of hedging against falling natural gas prices while still be able to benefit from a rise in natural gas price is to buy natural gas put options.

Learn More About Natural Gas Futures & Options Trading

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Continue Reading.

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

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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Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

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

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

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What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

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Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Hedging Against Rising Gasoline Prices using Gasoline Futures

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

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

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

Gasoline Futures Long Hedge Example

A motor fuel distributor will need to procure 5,000 kiloliters of gasoline in 3 months’ time. The prevailing spot price for gasoline is JPY 31,820/kl while the price of gasoline futures for delivery in 3 months’ time is JPY 32,000/kl. To hedge against a rise in gasoline price, the motor fuel distributor decided to lock in a future purchase price of JPY 32,000/kl by taking a long position in an appropriate number of TOCOM Gasoline futures contracts. With each TOCOM Gasoline futures contract covering 50 kiloliters of gasoline, the motor fuel 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 motor fuel distributor will be able to purchase the 5,000 kiloliters of gasoline at JPY 32,000/kl for a total amount of JPY 160,000,000. Let’s see how this is achieved by looking at scenarios in which the price of gasoline makes a significant move either upwards or downwards by delivery date.

Scenario #1: Gasoline Spot Price Rose by 10% to JPY 35,002/kl on Delivery Date

With the increase in gasoline price to JPY 35,002/kl, the motor fuel distributor will now have to pay JPY 175,010,000 for the 5,000 kiloliters of gasoline. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the gasoline futures price will have converged with the gasoline spot price and will be equal to JPY 35,002/kl. As the long futures position was entered at a lower price of JPY 32,000/kl, it will have gained JPY 35,002 – JPY 32,000 = JPY 3,002 per kiloliter. With 100 contracts covering a total of 5,000 kiloliters of gasoline, the total gain from the long futures position is JPY 15,010,000.

In the end, the higher purchase price is offset by the gain in the gasoline futures market, resulting in a net payment amount of JPY 175,010,000 – JPY 15,010,000 = JPY 160,000,000. This amount is equivalent to the amount payable when buying the 5,000 kiloliters of gasoline at JPY 32,000/kl.

Scenario #2: Gasoline Spot Price Fell by 10% to JPY 28,638/kl on Delivery Date

With the spot price having fallen to JPY 28,638/kl, the motor fuel distributor will only need to pay JPY 143,190,000 for the gasoline. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the gasoline futures price will have converged with the gasoline spot price and will be equal to JPY 28,638/kl. As the long futures position was entered at JPY 32,000/kl, it will have lost JPY 32,000 – JPY 28,638 = JPY 3,362 per kiloliter. With 100 contracts covering a total of 5,000 kiloliters, the total loss from the long futures position is JPY 16,810,000

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the gasoline futures market and the net amount payable will be JPY 143,190,000 + JPY 16,810,000 = JPY 160,000,000. Once again, this amount is equivalent to buying 5,000 kiloliters of gasoline at JPY 32,000/kl.

Risk/Reward Tradeoff

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

An alternative way of hedging against rising gasoline prices while still be able to benefit from a fall in gasoline price is to buy gasoline call options.

Learn More About Gasoline Futures & Options Trading

You May Also Like

Continue Reading.

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

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. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

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

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    1st Place! Best Binary Broker 2020!
    Best Choice for Beginners — Free Education + Free Demo Acc!
    Sign-up and Get Big Bonus:

  • Binomo
    Binomo

    2nd place! Good choice!

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