Hedgers Who Trade Commodities in Futures Contracts - dummies

Hedgers Who Trade Commodities in Futures Contracts

By Amine Bouchentouf

One group who trades commodities in the futures market is commercial producers and consumers of commodities who use the futures markets to stabilize either their costs (in the case of consumers) or their revenues (in the case of producers). They take advantage of the futures markets’ liquidity and leverage to implement their trading strategies.

If you ever get involved in the futures markets, it’s important to know who you’re up against.

Hedgers are the actual producers and consumers of commodities. Both producers and consumers enter the futures markets with the aim of reducing price volatility in the commodities they buy or sell. Hedging gives these commercial enterprises the opportunity to reduce the risk associated with daily price fluctuations by establishing fixed prices of primary commodities for months, sometimes even years, in advance.

Hedgers can be on either side of a transaction in the futures market, the buy side or the sell side. Consider a few examples of entities that use the futures markets for hedging purposes:

  • Farmers who want to establish steady prices for their products use futures contracts to sell their products to consumers at a fixed price for a fixed period of time, thus guaranteeing a fixed stream of revenues.

  • Electric utility companies that supply power to residential customers can buy electricity on the futures markets, to keep their costs fixed and protect their bottom line.

  • Transportation companies whose business depends on the price of fuel get involved in the futures markets to maintain fixed costs of fuel over specific periods of time.

To get a better idea of hedging in action, consider a hedging strategy that the airline industry uses.

One of airline executives’ biggest worries is the unpredictable price of jet fuel, which can vary wildly from day to day on the spot market. Airlines don’t like this kind of uncertainty because they want to keep their costs low and predictable. So how do they do that? They hedge the price of jet fuel through the futures market.

Southwest Airlines (NYSE: LUV) is one of the most active hedgers in the industry. At any one point, Southwest may have up to 80 percent of a given year’s jet fuel consumption fixed at a specific price. Southwest enters into agreements with producers through the futures markets, primarily through OTC agreements, to purchase fuel at a fixed price for a specific period of time in the future.

The benefit for Southwest is that the company has fixed its costs and eliminated the volatility associated with the price fluctuation of jet fuel. This action has a direct impact on Southwest’s bottom line. The advantage for the producer is that it now has a customer who’s willing to purchase the product for a fixed time at a fixed price, thus guaranteeing a steady stream of cash flow.

However, unless prices in the cash market remain steady, one of the two parties who enters into this sort of agreement may have been better off without the hedge. If prices for jet fuel increase, the producer has to bear that cost and deliver jet fuel to the airline at the agreed-upon price, which is now below the market price.

Similarly, if prices of jet fuel go down, the airline would have been better off purchasing jet fuel on the cash market. But because these are unknown variables, hedgers still see a benefit in entering into these agreements, to eliminate unpredictability.