A producer of oil will very likely be a crude oil producer, as refined products production is exposed to both the crude input cost and the prevailing price of refined products and therefore a different hedge and not considered an outright producer.

If you are a producer of crude oil, then you are exposed to price falls in the future of the physical crude oil market you sell into.

Given this, there is only one way to hedge against price falls, and this is by selling a derivative contract which will rise and fall as closely as possible in line with the physical oil price you are selling.

The first job, therefore, is to find a contract that closely represents the physical oil product you consume, based on the product type first, then the location and lastly the specification if applicable.

Once you have the right contract, it is about selling the right contract month, again that most closely aligns with the physical oil you are trying to sell.

Example:

A Private Equity backed crude oil producer owns an oil field in the North Sea. The firm invested in ensuring 1000 barrels per month are produced each month, with the cost of extracting the crude oil and delivered to market at $50 per barrel.

The firm is therefore in trouble financially if at any point the sellable price in the market goes below $50 per barrel. As the firms funding provides at least 2 years runway of operations, the executive team decides that they do not want to leave themselves vulnerable to crude oil prices moving downwards. They therefore decide to hedge their production 2 years out.

The executive team identify the Dated Brent oil swap contract as the closest derivative contract to their underlying physical oil. Dated Brent is priced using other North Sea oil fields, and so the economics should be tightly correlated.

The executive team ask for a buying price for Dated Brent contracts for January 2025 through to December 2026, for 1,000 barrels settling each month, for a total volume of 24,000 barrels. They sell this at $60 per barrel and can now simply allow this contract to settle and receive a positive cash balance if the derivative prices settle below $60 per barrel on average during this period, or a negative cash balance if the prices settle above $60 per barrel.

As the underlying physical crude oil price that they are selling into when the physical crude oil is ready to be sold is very closely correlated to the Dated Brent contract, any gain or loss should be offset by at least 98%. The firm is therefore happy that the prices they receive for their physical will guaranteed above $50 per barrel and therefore a high degree of certainty on their gross profit margins. They can now concentrate on ensuring operational costs are managed efficiently, and not have to worry about unfavourable price moves.