Question

t is now July 2016. Consider the following Futures Market for 1,000 barrels of Crude Oil:

Crude Oil Market (price per barrel, for 1,000 bbls.)
Date	Jul-16	Nov-16	Feb-16
Spot Price	35.00	35.00	39.00
December 2016 Futures Price	33.00	34.25	exp.
March 2017 Futures Price	37.00	38.00	39.75

Suppose you are the CFO of an independent oil refiner. You will need to purchase 500,000 barrels of Crude Oil in November 2015 and February 2016 on the spot market. Please devise a hedging strategy for the company, assuming you are only allowed to use ‘front month’ contracts – meaning that in July 2015 (now) you can only hedge with the December 2016 futures contract. When that position is closed at the price indicated, then you can use the March 2016 Futures contract.

What would the average price have been if you simply purchased the oil in the spot market?

Answer 1

Solution

Date	Jul-16	Nov-16	Feb-16
Spot Price	35.00	35.00	39.00
December 2016 Futures Price	33.00	34.25	exp.
March 2017 Futures Price	37.00	38.00	39.75

Hedging strategy:

For November 16 : Purchase the December 16 future contract and sell this future contract in Nov 16 and buy the crude oil from the spot market

• Purchase the future contract at 33.00 sell them in Nov future price at 34.25. Gain = 34.25 -33 = 1.25
• Purchase the crude oil from spot market at 35
• Effective purchase price = spot price - gain from future = 35 - 1.25 =33.75

For Feb 17: Purchase the March 17 future contract and sell this future contract in Feb 17 and buy the crude oil from the spot market.

• Purchase the future contract at 38.00 sell them in Nov future price at 39.75 , Gain = 39.75 - 38 = 1.75
• Purchase the crude oil from spot market at 39
• Effective purchase price = spot price - gain from future = 39 - 1.75 =37.25

Average price = (33.75 +37.25 )/2 = 71 /2 = 35.5

If you have simply purchased fro the open spot market without hedging then

average price = (35 + 39 )/ 2 = 74/2 = 37

So effectively you are gaining $1.5