Question

1. Below, you will see a pricing curve for Oil Futures. Your client is an oil producer (they are extracting oil from the ground and selling it to refineries)    They wish to hedge their estimated production for March 2021, June 2021, and September 2021.

Oil Pricing Curve

June 2020 $52.35

Sept 2020 $51.00

Dec 2020    $50.05

Mar 2021 $48.10

June 2021 $47.15

Sept 2021    $44.25

1. Oil future prices are said to be in __________.
2. What hedge rates could your client lock into today for Mar21, Jun21, and Sep21?
3. On settlement date for each of the 3 hedges, assume the spot price of oil has dropped to $38.00 per barrel. Show the calculations (2 steps) of the settlement for each of the above three dates. ($38.00/barrel is the price for each of the three dates)

Answer 1

Part A:-

Backwardation refers to the market condition wherein the price of a commodities' futures contract is trading below the current prevailing spot price. A market in backwardation has a forward/futures curve that is downward sloping.

In the above example, the future contracts of the Oil Pricing curve exhibits a downward sloping trend.

Hence, Oil future prices are said to be in "Backwardation".

Part B:-

The client is an oil producer who sells oil to the refineries. Hence, he would enter into a contract to sell his production at the respective maturities.  

Hedge rates for the respective maturities will be equivalent to the current prevailing forward/future rates for each maturity. Following hedge rates can be locked in by the client :-

Mar 2021: $48.10

June 2021: $47.15

Sept 2021: $44.25

Settlement Calculation:-

Spot Price for each settlement date = $38

Settlement calculation is as follows:-

Mar 2021: $(48.10-38) = $10.10 (Profit)

June 2021: $(47.15-38) = $9.15 (Profit)

Sept 2021: $(44.25-38) = $6.25 (Profit)