This sort of cuts through the fog12 Aug 2022 09:06
lord gnome: greygeorge et al. An illustration: It is January, and Company A wants to hedge forward some of its December production to guarantee its income. It agrees with a hedging counter-party to hedge 100,000 barrels of oil for December production at the current market price - say $100 per barrel. December comes and the price of oil is $100. The hedge expires and there is no cost and no profit to either party (other than the admin/insurance cost of the hedge). If December comes and the price of the oil sold is just $50 then the hedging company pays Company A the difference, i.e. 100,000 X $50 = $5 millions. Company A gets its money thanks to the hedge. If December comes and the price of the oil sold has increased to $150, then Company A sells the oil for $150 but must pay the excess to the hedging counter-party. In this scenario it is the hedging company that receives the 100,000 x $50 =$5 millions. Are you with me so far? This is simple maths. Company A is not trading oil (or gas) it is not trading futures, it is merely insuring its trading income by way of hedging. In DEC's case this keeps the banks happy and also the shareholders happy as it pretty much guarantees our dividends come what may. Now for the difficult bit. Stay with me. Mark to Market Situations. The hedge is taken out in January, but prices can move about a bit. In June, when the company reports its half year figures, the price of oil has risen to $120. If this prevails until December, Company A will owe the hedging company 100,000 X $20 =$2 millions, when the oil is sold, being the excess price receivable over the hedging level. This is therefore a mark to market loss of $2 millions on the hedge and must be reported with the half year results (ring any bells?). Come December, the price is still $120 per barrel. The oil is sold. The company keeps the $100 per barrel and the $20 goes to the hedge counter-party. The Mark to Market loss disappears and the hedge has been paid out from oil sale proceeds. Now do you understand? I have tried to keep this very simple for you. In reaity, DEC will have lots of hedges running at various future dates and for various amounts of production to ensure that income matches liabilities. It keeps the banks and shareholders happy. We are insured when things turn bad, but we relinquish some of the upside when things go well. If you still don't follow me, I give up. Good night and sleep well. Rusty knows what he is doing even if you don't.