Question

1. Looking at the recent drop in price of crude oil, would you advise an Oil Exporting Country to to hedge ? Explain what instruments they can use and what will be the opportunities and risks for them when price changes (goes up or goes down) from where it fell-to in

Answer 1

Yes, the oil-exporting countries must hedge. Hedging would help the oil producer against any adverse price fluctuations and ensuring that they get a fixed price for their produce at a future time, at the expense of foregoing any potential gain due to appreciation in oil price.

Oil exporting countries can use forwards, futures, or put options to hedge the price changes.

A forward is an over-the-counter instrument used to fix a particular rate in the future when the buyer has the obligation to buy the underlying at that fixed price and the seller has to deliver the underlying at that price, irrespective of the spot price prevailing in the market at its maturity. The future is similar to forwards, but are standardized contracts that are traded on an exchange, hence carry negligible counter-party credit risk and hence are less risky than forwards. Let's say the countries lock in a 6-month future price of $25 per barrel of oil. After 6 months, the oil producer will sell the oil at $25 and the customer will purchase at the same price. If the spot price of the oil is $30 per barrel after 6-months, the producer is still obligated to sell at $25 and loses out $5 due to the hedge. Conversely, if the spot price of the oil is $00 per barrel after 6-months, the producer will gain $5.

Similarly, a put option can be used to hedge the price fluctuations. Here, the oil producer buys a put option on the oil prices. Any decrease in the oil prices in the future results in a loss to the producer since he/she now has to sell the oil produce at a lower rate. However, this loss is compensated by an equivalent profit from the options contract where a put option will pay the differential between the strike rate when the option was purchased and the spot rate at the maturity. If the price rises at the time of selling, the oil producer benefits while the put option expires worthless. This way any adverse movement in oil prices is hedged.