Hedging Against Rising Coal Prices using Coal Futures

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Contents

Hedging Against Rising Coal Prices using Coal Futures

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

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

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

Coal Futures Long Hedge Example

A power company will need to procure 155,000 tons of coal in 3 months’ time. The prevailing spot price for coal is USD 74.45/ton while the price of coal futures for delivery in 3 months’ time is USD 74.00/ton. To hedge against a rise in coal price, the power company decided to lock in a future purchase price of USD 74.00/ton by taking a long position in an appropriate number of NYMEX Coal futures contracts. With each NYMEX Coal futures contract covering 1550 tons of coal, 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 155,000 tons of coal at USD 74.00/ton for a total amount of USD 11,470,000. Let’s see how this is achieved by looking at scenarios in which the price of coal makes a significant move either upwards or downwards by delivery date.

Scenario #1: Coal Spot Price Rose by 10% to USD 81.90/ton on Delivery Date

With the increase in coal price to USD 81.90/ton, the power company will now have to pay USD 12,693,725 for the 155,000 tons of coal. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the coal futures price will have converged with the coal spot price and will be equal to USD 81.90/ton. As the long futures position was entered at a lower price of USD 74.00/ton, it will have gained USD 81.90 – USD 74.00 = USD 7.8950 per ton. With 100 contracts covering a total of 155,000 tons of coal, the total gain from the long futures position is USD 1,223,725.

In the end, the higher purchase price is offset by the gain in the coal futures market, resulting in a net payment amount of USD 12,693,725 – USD 1,223,725 = USD 11,470,000. This amount is equivalent to the amount payable when buying the 155,000 tons of coal at USD 74.00/ton.

Scenario #2: Coal Spot Price Fell by 10% to USD 67.01/ton on Delivery Date

With the spot price having fallen to USD 67.01/ton, the power company will only need to pay USD 10,385,775 for the coal. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the coal futures price will have converged with the coal spot price and will be equal to USD 67.01/ton. As the long futures position was entered at USD 74.00/ton, it will have lost USD 74.00 – USD 67.01 = USD 6.9950 per ton. With 100 contracts covering a total of 155,000 tons, the total loss from the long futures position is USD 1,084,225

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Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the coal futures market and the net amount payable will be USD 10,385,775 + USD 1,084,225 = USD 11,470,000. Once again, this amount is equivalent to buying 155,000 tons of coal at USD 74.00/ton.

Risk/Reward Tradeoff

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

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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.

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Writing Puts to Purchase Stocks

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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

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. ]

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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. ]

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Valuing Common Stock using Discounted Cash Flow Analysis

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Hedging Against Rising Coal Prices using Coal Futures

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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