Commodities Trading as Hedging

Locking in Commodities Prices in the Future

Both suppliers and end users of commodities look to trade commodities futures to add some short-term security to their business needs. This is called hedging because the goal of these trades is to offset losses from future fluctuations in price, over the term of the contract.

The goal of this is to allow a business to look to add some certainty to commodity prices in order to make more informed short-term business decisions. A good example of the benefits of this would be with an airline looking to offset potential losses due to pricing their fares too low to make up for future increases in fuel prices.

Commodities Trading as HedgingSo, they can buy contracts for jet fuel, and if the price of the jet fuel is higher when the contracts expire, they can buy the jet fuel they need at the locked in price of the futures contract. During this time, they have been pricing their fares according to an expected future price for fuel, as people book flights in advance.

Knowing how much it will cost to fuel the planes allows them to act with more certainty with their pricing of fares and avoids them taking bigger losses if the price moves against them from the time the fares are booked and the flights occur.

If, at the expiry of the contract, the price moves down, in their favor in other words, they will still pay the contracted price if they settle the contract, although they do have the option of rolling it over to look to use it in the next contract period. In any case, the idea here is that they are willing to sacrifice the benefits of the price going down and their making more money in favor of their not losing money from price increases in the commodity they are trading.

While this is a risk averse strategy, the opposite of speculation, which is risk seeking, businesses tend to be somewhat risk averse due to the need to protect their business results and preserve shareholder value. Shareholders and the market doesn’t like underperformance, and this can impact things, the share price, beyond the nominal amount of these losses.

When we see a company’s quarterly earnings come in lower than expected, this tends to reduce the demand for the stock often times, and this is the sort of thing that depresses stock prices. The more stable earnings are, the less likely this is to happen, even if the overall earnings are less.

There are other reasons why a company wants to seek stability in their costs, such as interest payments that need to be made on shortfalls, in addition to their potentially exceeding their ability to borrow.

The Benefits and Costs of Commodity Hedging

Commodities trading is a zero-sum game though, so the expectations with trading futures contracts is a neutral one. Long term, when this all balances out, you aren’t going to either hurt yourself or help yourself from a nominal perspective, in other words from an overall impact on profits, so there’s no long time real downside to buying inputs at an agreed upon price in the future.

Since there is a real benefit to hedging for businesses, this is definitely something that they are interested in pursuing, and the commodities futures markets have been around for a long time and are very vibrant for this very reason.

This functions a lot like insurance does, without the premium. With insurance, the outcome is negative by nature because someone needs to take on the risk, and also make a profit, and therefore insurers need to collect more than their expected payouts or they will just go out of business.

Aside from the trading costs, which are negligible for hedgers, there isn’t a premium involved in the long run in commodities futures contracts. A certain trade of course will yield a certain gain or loss relative to the spot market at contract expiration, but these differences will even out over time and the net result will be no gain or benefit other than being able to conduct your business with more certainty, which is always a good thing.

The same things apply to commodity producers looking to lock in a certain price at a certain time for their commodities. Like commodity users, they have certain costs, and want to co-ordinate their revenues with these costs as best they can, and futures contracts allow them to do so.

When these contracts are settled, the spot price of the commodity may be higher, in which case the producer would have been better off not selling the contract, or it may be lower, where the producer benefits from the contract.

In the end though, the expectation is that these potential gains and losses will offset themselves pretty much, making this hedging like a virtually free bet of sorts, with the net result being that they can conduct their affairs with a much better idea of what their revenue streams will be in the near term.

This is a lot like having the ability to look into the future for a period of months, into a crystal ball of sorts, and this particular crystal ball is always right, and you can use this information to manage your business with.

Commodities Hedging Does Involve Some Speculation Though

Any time anyone trades securities, there will be some speculation involved, even though the intention of the trade may not be to speculate. The difference between hedging and speculating is that the goal of the trade isn’t capital accumulation, like it would be with a commodities speculator, it is instead to protect against undesirable fluctuations in price.

Companies who use and produce commodities do have some pretty good knowledge about the commodities being traded though. If a company is in the oil business for instance, or are a large agricultural producer, it is their business to have intimate knowledge about the businesses they are in.

Even though it is the case these days that information about markets are pretty transparent, and trading on knowledge not available to the public with certain securities, stocks for instance, are forbidden, the extent of the knowledge of a certain commodity that is used by a company is certainly going to be of use in their trading the commodity.

The positions these companies take do not tend to be related to the market, and are entered in instead to satisfy their business needs, this can influence the timing of things though if they wish to benefit a little from speculating on the commodities.

So, speculation does play some role in all this even though the intent is to hedge, much like someone who is looking to offset positions in the stock market might look toward holding gold to take the edge off of their overall market exposure and risk. In this case, these hedgers will often look to the price of gold to time their entry and exit points, and not just buy it and hold it blindly.

If this were not the case, then hedgers would just enter into futures contracts at the start of the contract period and not become involved at all during the life of the contract. This isn’t really the case though, as hedgers do trade the contracts throughout their cycle, alongside speculators.

It is only fairly recently that commodities speculation has surpassed hedging as far as the volume of futures contracts traded, and hedgers have always been heavily involved in the market. Due to the sheer growth of the popularity of trading futures among speculators, this has led to a large increase in their participation.

This has only benefited the market as it has added more liquidity to it, with both hedgers and speculators benefiting from this. The more participants in a market, the more efficient it is, and liquidity is the fundamental reason why futures exchanges exist, or any financial exchange, or any sort of market, to bring traders together.

There are some people in the commodities business who feel that the extent of speculation in futures markets is not beneficial to the market, with a belief that the market exists primarily for the purpose of hedging and therefore we must limit those who trade for other purposes, which includes both individual investors as well as institutional ones such as hedge funds.

In spite of how heavily regulated financial markets are, you just can’t keep people out of a market like this, as this violates the fundamental principles of a free market, to be free in other words.

It is true that speculation does add to intra-contract volatility, the price moves more in other words by having more people who are looking to make money on the markets, but none of this affects the ultimate price for the commodities.

The only way to do that is to increase the demand or decrease the supply of the commodities themselves, and since speculators do not sell or buy the commodities themselves, this cannot affect spot prices at all. The spot price at the end of the contract is what decides the trade, not how high or low some people think that price will be at expiration.

Those who bet on the wrong side will lose money and those placing better bets will gain, and this is the case with both hedgers and speculators. Having more skilled traders in a zero-sum market like this will see some money flow from the less skilled to the more skilled, but that’s the nature of financial markets regardless.

Hedging does provide those who use and produce commodities with a great way to manage their businesses, and it also provides traders with a means to make money if they are good enough at this, and both objectives can and do work well alongside each other.

Ken Stephens

Chief Editor, MarketReview.com

Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.

Contact Ken: ken@marketreview.com

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