How Commodity Hedging Works

The futures market is based on speculators and commercials. You need both parties to keep things running smoothly because in every long position there has to be a party that takes the short position and vice versa. Today I would like to introduce you to a use case that is very important for commercial players in the market and has generally speaking less to do with trading (in terms of speculating)

“Hedging price risk” - Using the financial markets to hedge against the physical market.

What is the basic idea of hedging?

If the movements of commodity prices can impact your business, you might consider hedging to reduce your exposure. A hedge is an investment made to reduce the risk of adverse commodity price movements. Typically, your hedging strategy takes an offsetting position in a derivative or a related security. It’s not an investment with the intention to make money over the long term it’s an investment that should offset volatility in the price of a commodity you will have to buy or sell in the near future.

Why and which people need hedging in the commodity sector?

There are many reasons for people to hedge against commodity price risk. In my experience, most of the time the group of people who need this kind of protection are suppliers of commodities like farmers and producers but also sourcing specialists of small and big corporations at the demand side of the equation. Those groups can range from grain and livestock producers to ethanol producers to food and feed manufacturers. For many commodity trading firms like Trafigura, Cargill or Glencore, hedging is simply a necessity.

Both the supplier and the buyer of the goods have a high interest in having tight risk management strategies when it comes to price fluctuations. Calculating risk is the single most important factor when it comes to hedging as a part of trading risk management in the physical commodity world.

Why use futures contracts as a hedge?

Futures are the most popular asset class used to hedge against risk. This approach to a future agreement between two parties is already used for decades and was first introduced in the 1800s.

Moreover purchasing and selling futures is “cheap” from a cost aspect and these financial instruments are most of the time also very liquid.

What kind of hedges are there?

It is always easier to explain the concept via a practical example. So here we go. Just imagine you’re a farmer and you plant Wheat which you’re planning to sell after the harvest, half a year from now.

Short Futures Hedge

You can use a short futures hedge to offset the risk of prices falling by the time you harvested the Wheat and sell it on the open market.

1. Sell Wheat Futures to cover the amount of Wheat you plan to sell at a future date
2. Sell physical Wheat in the cash market as planned
3. Buy back your short Wheat positions

Long Futures Hedge

If you know that you will need to buy urea-based fertilizers in the near future, you will be disadvantaged if prices increase in the meantime. Therefore you can use a long hedge to control that risk.

1. Buy a Fertilizer Futures contract to cover the amount of acre you need to provide for
2. Purchase Fertilizers in the cash market when actually needed
3. Offset your long Fertilizer Futures contract

Those basic strategies can of course be adjusted via using futures options or via hedging only a percentage share of the whole delivery/crop.

Important takeaways from this short explainer

• Hedging is a way to reduce risk exposure by taking an offsetting position in a closely related product or security.
• In the world of commodities, both consumers and producers of them can use futures contracts to hedge.
• Hedging with futures effectively locks in the price of a commodity today, even if it will actually be bought or sold in physical form in the future.

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