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I wanted to know how does company like trafigura hedges against price risk?

Example if trafigura agrees to sell say a barrell of WTI crude oil @ $56 3 months hence. How would they hedge it?

Would they buy futures for the same today and sell it after 3 months when they deliver the physical commodity as well?

I cannot understand the cash flow for different scenarios like contango or backwardation.

  • Lead sentence from an article earlier this year: "One of the world’s biggest traders, Trafigura, booked a $254 million (£195 million) loss from oil and gas market hedges last year." In answer to your question, I'd say that they're not doing a very good job of hedging. – Bob Baerker Nov 3 at 16:56
  • @BobBaerker so how are they sustaining the operations with such huge losses? Are the losses offset by gains in physical trade? – Rohan Nov 3 at 16:58
  • @BobBaerker I want to know how should they do it theoretically so that I can answer in job interview. – Rohan Nov 3 at 17:00
  • In order to sustain the operations with such huge losses, they have to have sufficient assets to satisfy the minimum margin maintenance requirement (whatever that is wherever they are located). As for hedging, I could help with the equity side but not futures. Do some Googling and read about the various ways of hedging futures. – Bob Baerker Nov 3 at 17:38
  • @BobBaerker Hedges aren't supposed to make money. They're supposed to eliminate risk. Losing money in hedges simply means that their hedges lost money and offset gains in normal operations. – D Stanley Nov 4 at 13:11
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With contango, a long-term futures contract will decline to the spot price as the time winds down. So an advantageous position would be to hold the sell-side of a long-term futures contract while also holding the physical commodity. And here storage of the physical commodity is the effective business practice.

With backwardation, a long-term futures contract will rise to the spot price as the time winds down. So a advantageous position would be to hold the buy-side of a long-term futures contract while not holding the physical commodity but sourcing the physical commodity as needed. And here the ability to quickly source and ship the physical commodity is the effective business practice. Note that the physical commodity is owed to forward sales.

Since the company mentioned has hedging losses, it was probably logistically necessary to hold large amounts of physical commodity and then necessary to hedge with sell-side futures. The sell-side futures would be expected to be short-term futures rolled over at each expiration because the oil market is in backwardation.

Look at the subject another way and when the market is in backwardation then there is no positive premium for forward sales of the physical commodity. But since something sold forward is stored but held as a short position then go-back to paragraph two.

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if trafigura agrees to sell say a barrel of WTI crude oil @ $56 3 months hence. How would they hedge it?

There is no need to hedge in this case. I assume they they are guaranteed to own the oil in this scenario, and they already have a future price locked in, so there's no risk to hedge.

Now, on the other hand, if they were going to sell oil in three months are market prices, then they would have price risk. To offset that risk, they could buy futures that expire in three month and then sell them on the day of expiry (to avoid physical delivery).

Oil producers are less inclined to hedge in a contango market, because there is a reasonable expectation for the future price to increase. However, that depends on the reason for the backwardation. If there is backwardation because of a short-term supply shortage, then the future price may be reasonable and hedging might be prudent.

But again, hedging is not about trying to profit on future misprices - it is about eliminating risk.

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