Hedging in Commodities and How it Works
The commodity markets are primarily made up of speculators and hedgers. It is easy to understand what speculators are all about - they are taking on risk in the markets to make money. Hedgers are a little more difficult to understand.
A hedger is basically a person or company that is involved in a business related to a particular commodity. They are usually a producer of a commodity or a company that needs to purchase a commodity in the future. Either party is trying to limit their risk by hedging in the commodity markets.
The easiest example to associate to a hedger is a farmer. A farmer grows crops, soybeans for example, and has the risk that the price of soybeans will decline by the time he harvests his crops in the fall. Therefore, he would want to hedge his risk by selling soybean futures, which locks in a price for his crops early in the growing season.
A soybean futures contract on the CME Group exchange consists of 5,000 bushels of soybeans. If a farmer expected to produce 500,000 bushels of soybeans, he would sell 100 contracts of soybeans.
Let us assume the price of soybeans is currently trading at $13 a bushel. If the farmer knows he can turn a profit at $10, it might be wise to lock in the $13 price by selling (shorting) the futures contracts. The risk is that the price of soybeans could fall below $10 by the time he harvests and is able to sell his crops at the local market.
There is always the possibility that soybeans could move much higher by harvest time. Soybeans could move to $16 a bushel and the farmer could make huge profits. The opposite could also happen - soybean prices could tank and the farmer could incur a substantial loss. The main part of the business is survival and earning a decent profit, not how much money you can make while throwing caution to the wind. That is what hedging is all about.
Two Parts to a Hedge
There are two parts to a hedge. A position in a commodity (cash position) that is either being produced or has to be bought. The other side is the position in the futures markets that a hedger creates to limit risk.
The typical case is that one of the positions will move in favor of the hedger and the other will move against the hedger. A perfect hedge would have the hedge spread not change at all during the course of the hedge. This would make the hedger no better off or no worse off by the time the final goods are actually bought or sold.
The Ins and Outs of Hedging
Most people would think that hedgers would initiate a hedge as soon as possible to make sure they don’t have any risk that prices could make a detrimental move before they have to buy or deliver a commodity. However, that is often far from the normal case.
Some companies don’t hedge or they rarely hedge. A good example of this is when the major airlines were caught sleeping when the price of oil climbed from $30 to nearly $150 a barrel. Many airlines suffered huge losses and some went bankrupt due to the high fuel costs.
If they had been hedging properly, a large portion of the losses could have been avoided. They still would have had to pay the higher fuel costs, but they would have made a substantial amount of profits on the futures positions. Most airlines are now very diligent about using a strict hedging program.
Farmers, for example, sometimes don’t hedge until the last minute. Grain prices often move higher in the June - July timeframe on weather threats. During this time, farmers watch prices move higher and higher, often getting greedy. Sometimes they wait too long to lock in the high prices and prices tumble. In essence, these hedgers turn into speculators.
The premise of hedging is why the commodity futures exchanges were originally created. It is still the main reason why futures exchanges exist today. Hedgers don’t make up the main volume of trading, but they are the main economic reason why exchanges exist. Speculators make up the bulk of the trading volume and the exchanges really wouldn’t exist without them.
Update on Hedging by Andrew Hecht on April 11, 2016
One of the most important characteristics of futures markets, when it comes to hedging, is convergence. Convergence is the price alignment between nearby futures prices and cash or physical prices during the physical delivery period. This makes futures markets attractive for producers and consumers in that it provides a true picture of the price they will receive or pay for the commodities being hedged.
Another important characteristic for hedgers is the ability to make or take actual physical delivery. In other words, a producer has the actual ability or right to deliver the commodity and a consumer has the right to receive the commodity as a result of holding a futures position until the delivery period and then choosing a delivery option. There are additional costs involved in making or taking delivery but those costs tend to be nominal.
Finally, while futures exchanges require hedgers to pay margin for their futures positions, the margin levels are often lower than for speculators or other market participants. The reason for lower hedge margins as exchanges view this community as less risky in that they either produce or consume a commodity, therefore, they have a position in the commodity that naturally offsets the futures position. A hedger must apply for these special margin rates through the exchange and be approved after meeting exchange criteria.