Introduction to hedging

Your job as a hedger is to find the contract that most accurately mimics the physical economics you are trying to hedge. You need to align the derivative contract volume and time with the physical volumes and time. And, you will have to weigh up liquidity vs accuracy of contract to get the best hedge for you. Here are the four hedger types, what type of hedger are you?

• Consumer
• Producer
• Refiner
• Oil Trader

Hedging is a different approach to trading than speculating. Hedging is when you are intending to mitigate risk. Think about 2022 and the cost-of-living crisis. Russia was about to invade Ukraine, and it was very clear oil prices across the board would likely rise. Key consumer products like gasoline, but also the cost of importing the products you use every day. What could you do about it?

You can protect yourself against future movements by buying a gasoline contract that will closely track the wholesale price of the gasoline you buy.

If you use gasoline every day in your car and intend to do so for at least the next two years, you are exposed to price movements in the gasoline market. If the price goes down steadily in the next two years, then you will likely have saved money. If it stays roughly the same, then you will not pay much attention. But, as a buyer, like it 2022, if it goes up a lot you will be paying a lot more.

So, in this example, as a gasoline consumer, you are a natural buyer of gasoline. If you want to protect yourself against future rises in the price, then you can buy an oil swap contract now, for the exact months you want to protect against. Let’s say you know you are going to do a lot of travelling in the summer – your gasoline consumption will be higher than usual. You can set aside an amount of cash that will cover that consumption. But unless you buy a summer contract with an oil swap, you are at risk of that cash not being enough to cover the gasoline consumption.

But before you fall too in love with this idea, you must first realise that this is not an exact hedge – or in other words, our oil swap contracts won’t move exactly in line with the gasoline you buy at the pump. We can’t offer that, yet. You can protect the wholesaler price, but not the price you receive, which includes government duties and taxes. This is a variable that can’t be accounted for in oil markets.

You also need to recognise that this exercise is about cash flow, not making money. If you think this is a guaranteed way to make money you are wrong. We are going to continuously repeat this and make you acknowledge this before you hedge.

You buy the gasoline contract with the intention to protect your savings for summer. The gasoline contract goes up, you generate a return on your cash in the oil swap contract, however you will still pay the higher price at the pump. The idea is to offset the rise at the pump with the rise in the oil swap.

Now consider the opposite. What if you buy the gasoline contract and it goes down by the time it gets to summer. You have lost money on this oil swap. However, the wholesalers price has gone down at the pump, and this should materialise in a relative saving on the price at the pump. Again, it is about offsetting the price at the pump with the rise in the oil swap.

If you lose and gasoline doesn’t go down – you are being taken advantage of by the local station. This is something again out of our control – but at least you will know. This is our mission.

Now this is a very good example of hedging, and this logic can be applied to any end user of any oil product, and of course any producer of any oil product

Hedging is an industry practice, from airlines to shippers to plastic companies. This is now about opening access to hedging for all, whether you are a large company, small or a regular joe.