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Example 3 - Petroleum Marketer's Long Hedge, Rising and Falling Markets Introduction Example 1 - Crude Oil Producer's Short Hedge Example 2 - Electricity Producer Fears a Price Decline Example 3 - Petroleum Marketer's Long Hedge, Rising and Falling Markets Strip Trades Spread Trades On September 7, the New York Harbor price for heating oil is 55¢ and the cash market price at the fuel dealer’s location is 54¢ a gallon, a 1¢ differential, or basis, between New York Harbor and the retailer’s location. The dealer agrees to deliver 168,000 gallons to a commercial customer in December at 70¢ per gallon. On September 7, he buys four December heating oil contracts (42,000 gallons each) at 57¢, the price quoted that day on the Exchange’s NYMEX Division. Total cost: $95,760 (42,000 x 4 x $0.57). Case 1 – Rising Prices On November 25, the fuel dealer buys 168,000 gallons in the cash market at the prevailing price of 59¢ a gallon, a 1¢ differential to the New York Harbor cash quotation of 60¢, Cost: $99,120. He sells his four December futures contracts (initially purchased for 57¢) at 60¢ a gallon, the current price on the Exchange, realizing $100,800 on the sale, for a futures market profit of $5,040 (3¢ a gallon). His cash margin is 11¢ (the difference between his agreed-upon sales price of 70¢ and his cash market acquisition cost of 59¢ for a total of $18,480 ($0.11 per gallon x 168,000 gallons). Case 2 – Falling Prices On November 25, the dealer buys 168,000 gallons at his local truck loading rack for 49¢ a gallon, the prevailing price on that day, based on the New York Harbor cash quotation of 50¢ a gallon. He sells his four December futures contracts for 50¢ a gallon, the futures price that day, realizing $84,000 on the sale, and experiencing a futures loss of $11,760 (7¢ a gallon). In summary, the fuel retailer guarantees himself a margin of 14¢ a gallon regardless of price moves upwards or down in the market. With the differential between cash and futures stable, as in Cases 1 and 2, spot-price changes in either direction are the same for both New York and the marketer’s location. As a result, a decline in the futures price, which causes a loss in the futures market, is offset cent-for-cent by the increase in the cash margin. Source: