Futures, forwards and swaps simplified.
The first decision for any commodity producer is whether to hedge, the second is how. This is the second paper in a planned series of risk management topics by Inside Out Advisors and here we introduce the basic instruments and strategies that are available to producers once this decision has been made.
Broadly speaking, hedging instruments fall into two categories: The first comprises futures, forwards, and swaps, and we examine these in more detail below. The second involves Options and the more sophisticated strategies that employ them will be the subject of our next article.
Futures, forwards and swap contracts achieve very similar hedging outcomes, allowing a producer to achieve a Fixed Price for their future production. A Future is simply a contract to buy or sell a commodity at a fixed price on a future date. These contracts are traded on an exchange and have standardised quantity, quality, delivery point and maturity dates. This standardisation aggregates the activity of market participants around a limited and defined set of nodes, greatly enhancing the liquidity of futures compared to bespoke OTC contracts.
A commodity producer wishing to hedge production can sell a future thereby creating an obligation to deliver an agreed quantity of a specific quality of commodity at the agreed fixed price for delivery on a known future date. The producer could deliver his production against this obligation on the contracted date, but in practice most producers will already have physical buyers for their material and will simply use the futures contract as a financial overlay to hedge the price risk. This price risk exists because generally the physical offtake contract with their natural buyer will stipulate volume, quality and timing, but the pricing will be left floating (unfixed). By overlaying a financial hedge this floating price risk can be transformed into a fixed price. As a result, a producer will normally unwind their original futures sale with an offsetting futures purchase prior to maturity of the contract, resulting in the elimination of that position (a zero position is generally known as a ‘Flat Position’ ) and a net cash flow. Let us look at an example to illustrate this process.
Consider an oil producer who expects to produce 100,000 barrels of WTI crude oil in November. The producer has contracted with a physical buyer to sell 70% of this volume at a floating price that is set according to the price of the December WTI crude oil futures at the time of delivery. Assume the current price for the December futures contract is $55/bbl. The first panel below is the initial leg of the hedge process and the following two panels represent the 2nd leg under two different scenarios
As the diagram illustrates the Total Cash received by the producer is now immune to the direction the underlying price takes.
Forward contracts achieve very similar hedging outcomes to Futures contracts but differ in their legal and operational characteristics. Whereas futures are traded on exchange and then matched and cleared by a Central Clearing House, forwards are negotiated and settled bi-laterally between the producer and the entity quoting the price for the hedge. This characteristic is referred to as Over-The-Counter (OTC). On the plus side this allows for customisation of volume, delivery dates and other non-standard specifications. The bespoke nature of these contracts can eliminate a lot of the basis risk discussed in our last article. It can also mean reduced cash flow issues relating to margin calls should the counterparty to the hedge extend credit terms to the producer. The main downsides are that the producer takes on the Credit Risk of the counterparty not performing on the hedge, and reduced Liquidity in the event the hedge needs to be unwound.
In the precious metals space forward transactions tend to be physically settled against metal account balances. However, with most other commodities, OTC forward transactions are commonly Cash-Settled against a reference price prior to the settlement date. In the industrial metals market an OTC forward transaction that is cash-settled against a single day’s reference price is referred to as a Bullet Swap. In the energy market these are generally just referred to as forwards, even though they are strictly speaking bullet swaps. A Swap is a cash-settled transaction where a floating price is exchanged (or ‘swapped’) for a fixed price, and it can be exchange-cleared or OTC. Whereas in the futures example above the producer had to manually unwind the initial hedge to produce a net cash flow and avoid physical settlement, with a swap contract this cash-settlement happens automatically. The mechanism for this is as follows:
At inception of the trade a fixed price and the terms for calculating the floating price, or Settlement Price, are agreed between the buyer and seller. The Settlement Price is calculated at the end of each averaging period of the swap contract as the simple average of the agreed benchmark Reference Price (eg 1st nearby Brent futures contract) observed for each of the days during the specified calculation window. The calculation window could be a single day (in the case of a bullet swap), or a longer period such as a calendar month. The difference between the Fixed Price and the Settlement Price multiplied by the Notional Quantity (e.g. barrels, tonnes) is a quantity of cash that is exchanged between the producer and the hedge provider. If the Settlement Price is greater than the Fixed Price then the producer must pay this sum to the hedge provider and vice versa if the Fixed Price is greater than the Settlement Price.
The core idea behind hedging with swaps is that if the floating price reference window on the physical offtake contract matches the floating price reference window on the swap contract, then the floating price risk cancels itself out leaving the fixed price piece of the swap. Let’s look at this visually:
Well designed and structured hedging programmes are an essential risk-management tool that producers can use to crystallise their forward cash-flow models allowing them to focus on long-term strategic goals and decision making. However, great care needs to be taken at the design and structuring phase of this process to avoid the many hidden traps. For instance, if production levels are subject to fluctuation it may be more effective to hedge only that volume that is guaranteed to be produced. Or for instance, if short-term free cash-flow is subject to severe constraints then it may be more prudent to use bilateral OTC swaps with a Credit-Line as opposed to Exchange based futures contracts which will call for payments of Initial Margin and daily Variation Margins as prices alter, putting huge pressure on short-term liquidity.
Some of these challenges can be avoided with the use of options hedging strategies, and we will cover these instruments in our next article
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