What is Oil hedging?

Answer 1

Hedging oil is a price control tool for someone engaged in the Oil Business. Depending upon their business they may be a BUY SIDE Hedger or a Sell Side Hedger.

Business people do not want risk. Speculators love risk. Hedging transfers risk from those that do not want it, to those that want it.

Let's start with a simple hedge, and then we'll explain buyside and sell side hedging in terms of Oil.

A farmer is thinking about growing corn. He sees by the price of corn in the futures market that growing corn would generate a good profit, but what if the price changes between right now and when the corn is grown? He could "lose the farm." So he hedges. He calls his broker and SELLS corn on the futures market today (SELLS SHORT.)

Three months later the corn has grown and he brings it to market, but the price has changed! Not to worry, he hedged. he receives $1 less per bushel due to the price change, BUT then he goes home and calls his broker and "OFFSETS" the hedge at the exchange resulting in a $1 per bushel profit. Viola! The exchange gain has offset the corn actuals market loss, and the farmer has earned his expected profit. The hedge saved the farm.

This is the most common and simple hedge - A SELL HEDGE.

So let's move that into the Oil Market.

Let's say you are an American Gas manufacturer. What do you need to make gasoline? Crude Oil. Every month you need crude to make gas. But what if the price of crude changes (Goes Up)? We could lose our potential profit! So we hedge. We go into the Crude Oil futures market and BUY August Crude today. We are now long in the market, and "hedged". When August comes, if the actual crude from our local supplier costs us more, we can offset the loss with our market profit. Inversely, if the local Crude cost us less than we expected, we take that savings to pay off our market loss.

Now take that same manufacturer AFTER he has converted the Crude, he HAS Gas. Now the same way the farmer HAS corn this guy HAS gas.

So in essence, the guy in this example could be a buy side hedger or a sell side hedger depending upon what stage of the business cycle he is in.

The trick to understanding the hedge is to ask yourself, do I HAVE IT LIKE THE FARMER (SELL HEDGE), or do I NEED ITLIKE THE IMPORTER (BUY HEDGE.)

HAVE IT is a sell Hedge (A farmer has corn. A fund Manager HAS stocks)

NEED IT is a Buy Hedge (A Jeweler NEEDS gold to make an order. An importer needs yen.) etc.