Question

Suppose you are a gas producer who would like to hedge future production. The current spot market price of gas is $3.00 and June 2018 futures price is $3.30. Explain whether you should long or short the futures contract in order to hedge the price risk associated with June 2018 production. What happens to the price of your production in June if June price is 3.60 if you are hedged or not hedged? 2.90? Explain.

Answer 1

Answer - producer should take short position on the future contract at $3.30.

Reason - a gas producer who wants to hedge future production to overcome risk of losses will have a fear of price of gas going down than the current price and he may suffer loss. To over come this risk he should short (sell) the future contract today and lock the sale price at $3.30. now irrespective of whatever the price be his price for gas sale in June 2018 will be locked at $3.30 which hedges the risk of price going down or any losses.

If price in June is $3.60, the producer will have a loss of $0.30

Reason - as the producer hedged the future value of gas by short selling future contract at $3.30, now he will have to Buy the futures at $3.60 to close the contract, which will cause him a loss of $0.30.

If the price in June is $2.90, the producer will have a profit of $0.40

Reason - as the producer hedged the future value of gas by short selling future contract at $3.30, now he will Buy the futures at $2.90 to close the contract, which will cause him a profit of $0.40 on whole transaction.

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