Question

Assume that you invest in oil, and you plan to sell 350,000 oil barrels in Dec 2020. You think that the price of oil in Dec would be in the range of $50 – $55 per barrel. Show how would you use the futures contract to hedge against oil revenue loss (assume each futures contract calls for the delivery of 1,000 oil barrels and the current futures price is $52.5 per barrel) or against a future price reduction (hint: develop a scenario, in a table, where you show the possible future scenarios with respect to the expected oil price range).

Answer 1

As you wish to hedge against a fall in oil prices, you should short the oil futures contract.

Number of futures to contract = number of barrels to sell / contract size = 350,000 / 1,000 = 350

You will short the futures contract at $52.50 today. As it is a short position, a rise in the futures price will result in a loss, and fall in the futures price will result in a gain.

Profit/loss on futures contracts = (futures price today - futures price in December) * number of contracts shorted * number of barrels per contract

In December, the futures contract will be closed at the oil price in December. The 350,000 barrels will be sold in the market at the oil price in December.

The scenarios are below :

We can see that the net proceeds are locked in at $18,375,000.

Thus, the futures contracts have hedged the net proceeds