Commodities · M6 · 8 min
Hedging for producers and consumers
Work out how many futures a business needs to protect its price, the price it ends up with, and what can still go wrong.
In the news: When an airline reports its fuel bill or an energy firm needs cash for margin calls, the story is about hedging.
The essentials
- Hedge
- A position that gains when the business loses. Consumers buy futures (a long hedge) and producers sell them (a short hedge). Futures bought at $80 lock in about $80 whether oil ends at $95 or $70.
- Hedge ratio
- The share of expected volume that is hedged, usually less than all of it because volumes are uncertain. Hedging 70% of 2.4m barrels with 1,000-barrel contracts takes 1,680 contracts.
- Basis risk
- is the local cash price minus the futures price. A hedger ends up with the locked-in futures price plus the basis at the end, so changes in basis are , usually far smaller than price risk.
- Options as hedges
- A caps a buyer’s price but keeps the saving if prices fall; a gives a producer a floor but keeps the gain if they rise. Both cost a fee up front.
- Margin and cash
- Futures losses are paid in cash every day as , while the matching gain on physical output arrives only when it is sold. In 2022 that left hedged European energy firms short of cash.
Contracts for a hedge
N = E ÷ Q × h
- N
- contracts to trade
- E
- the amount to hedge, such as barrels
- Q
- contract size
- h
- hedge ratio: the share hedged (0.7 for 70%)
How it works
1. Locking in a price
A fixed-price energy tariff means a household pays the same whatever happens to wholesale prices. Businesses do the same with futures. An airline worried about fuel can buy oil futures now: if prices rise, the gain on the futures pays for the dearer fuel. That protection is a hedge.
2. Producers sell, consumers buy
A consumer, like an airline or a bakery, loses when prices rise, so it buys futures: a long hedge. A producer, like an oil company or a farmer, loses when prices fall, so it sells futures: a short hedge. Either way, the futures gain when the business loses.
3. How many contracts
Futures come in fixed sizes, so divide: hedging 600,000 barrels with 1,000-barrel contracts takes 600. Most firms hedge only part of what they expect to use or produce, because their volumes are uncertain. The share hedged is the hedge ratio: 70% of 2.4m barrels is 2,400,000 ÷ 1,000 × 0.7 = 1,680 contracts.
4. The price a hedge locks in
An airline buys futures at $80. Later oil is $95: it pays $95 for fuel but gains $15 on the futures, so $80 overall. If oil falls to $70, it pays $70 but loses $10 on the futures: still $80. Effective price = price paid − futures gain.
5. Basis
The hedge works perfectly only if the price you actually pay moves exactly with the futures price. The gap between them is the : local cash price − futures price. If crude in West Texas sells for $1.20 less than the future, the basis is −$1.20.
6. Basis risk
Because the basis can change, a hedger ends up with the futures price it locked in plus the basis at the end. An airline hedging jet fuel with crude futures loses out if jet fuel’s premium over crude widens. That leftover risk is , usually much smaller than the price risk it replaced.
7. Options keep the upside
Futures fix the price both ways. An airline that wants protection from rises, but the saving if prices fall, can pay a fee for a : the right to buy at a set price. A producer can do the mirror image with a , the right to sell at a set price, which sets a floor.
8. Hedged, but short of cash
Exchange futures settle gains and losses in cash every day: . If prices spike, a producer that sold futures must pay its futures loss now, while the extra value of its oil arrives only when it sells. In 2022 that squeezed European energy firms, and the UK set up a scheme to guarantee bank loans for their .
Worked example
An airline expects to buy 3 million barrels of jet fuel next year and hedges 60% by buying Brent futures (1,000 barrels each) at $80.00. Jet fuel trades $18 above Brent. A year later Brent is $95.00 and jet fuel is $25 above it.
- Contracts: 3,000,000 ÷ 1,000 × 0.6 = 1,800 Brent futures, bought.
- Futures gain: 1,800 × 1,000 × ($95 − $80) = $27.0m.
- Jet fuel now costs $95 + $25 = $120 a barrel: $360m for 3m barrels.
- After the hedge: $360m − $27.0m = $333m, or $111 a barrel.
- Jet fuel’s premium over Brent widened from $18 to $25: that $7 a barrel is the basis risk the hedge didn’t cover.
1,800 contracts; fuel costs about $111 a barrel instead of $120, and the wider jet premium was a risk the Brent hedge never covered.
Check yourself
8 quick questions on the explanation above.
Practice
New numbers every set. Misses and guesses go into your review deck.
In the interview
Answer out loud in under a minute, then compare.
How should an airline hedge its fuel?
Why did some energy companies need emergency liquidity in 2022 even though they were hedged?
What’s basis risk?
Remember
Effective price = futures at the start + basis at the end
A hedge swaps price risk for basis risk, and an exchange hedge needs cash for margin before the physical gain arrives.
Sources
- Bank of England — Energy Markets Financing Scheme (EMFS)
- Bank of England — Financial Stability Report, July 2022: opening remarks
Definitions and maths are standard textbook material; dated facts link to the sources above. Worked numbers are illustrative.