t3.r12.c3.q5 Why selling short?

[Pflik]

I have a question about the answer given in reading 12 hull chapter 3. (question 5).

The question states that a contract has been negotiated to sell one million barrels of oil.

If i read it correctly, the oil producer already has an obligation to sell one million barrels of oil (and given the question, i would assume this is sold at spot price).

My intuition says that it should be a long hedge as you need to buy to fulfill a sell. (which would mean the oil producer needs to sell one million at spotrate now and enter a future/forward to fix changes in the spotprice)

However am I correct to assume that the intention of the oil producer is to have a short hedge to sell the oil at fix price, then buy at spot price to fulfill the obligation (sell) at spotprice?

I understand the basic concept, and i do realize this is a very basic question, but i'm just trying to check if my logic adds up as multiple answer seem to apply.

 

[David Harper CFA FRM]

Hi Pflik,

The key is the nature of the price risk of the underlying exposure, which in this context depends on whether the seller will be selling the oil (underlying commodity) at a predetermined price. Either:

• The produce plans to sell 1 million barrels at the future spot price, today unknown, whatever it may be (as in the question). In this case, even as they are a seller, the underlying price exposure is "long" the future commodity price; i.e., if the future spot price is high, the producer benefits. If the future spot price is low, the producer will be hurt and this is the motivation for the hedge. Or,
• The producer plans to sell 1 million barrels at predetermined price (as in the Metallgesellshaft case). Now the underlying exposure is "short" the future commodity price; i.e., if the future spot price is high, the producer is hurt. Because, in this scenario, the producer is effectively short a forward contract.

The hedge then simply offsets:

• If the underyling exposure is long, the hedge trade is a short hedge (i.e., short futures)
• If the underyling exposure is short, the hedge trade is a long hedge (i.e., long futures)

Re: the intuition to think about long/short in terms of "need a long in order to deliver a short," but you can see in the context of price risk hedge, in both cases we assume the producer already owns the commodity (or that the producer will be purchasing more of the spot as part of the underlying exposure). The market risk hedge (the Hull chapter, is really all we are talking about) concerns only the price risk; so, the logic of the hedge is: we want a futures position that produces a profit under the scenario where the underlying exposure produces a loss based on a price change

More here on these threads:

• https://forum.bionicturtle.com/threads/bt2012-p1-14-hedge-coffee-purchase.5768/#post-16552 follow-up thread
• http://forum.bionicturtle.com/threads/strip-hedging-stack-hedging.4703/ ; i.e., Metallgesellshaft as a use-case