In addition to companies seeking to hedge their exposure to energy commodity prices, swaps are also utilized by companies seeking to hedge their exposure to agriculture commodities, metals, foreign exchange rates and interest rates, among others.
As an example of how an oil and gas producer can utilize a swap to hedge its crude oil production, let's assume that you're an oil producer who needs to hedge your November crude oil production to ensure that your November revenue meets or exceeds your budget estimate of $45.00/BBL. If you had sold a November Brent crude oil swap at the close of business yesterday, the price would have been approximately $48.78/BBL.
Now let's take a look at how hedging with this Brent crude oil swap would impact your revenue, and in turn your cash flow, if the prompt month Brent crude oil futures contracts during the month of November average $10 higher and $10 lower than the $48.78 price at which you sold the swap.
It should be noted that because Brent crude oil futures expire on the last business day of the 2nd month proceeding the relevant contract month the January futures contract is the prompt futures contract during the March production month.
As a result, a November swap will settle vs. the January futures contract. If the swap were a WTI swap rather than a Brent swap, the settlement would be calculated against the December WTI futures contract from November 1 – November 21 (the expiration date of the December futures contract) and the January futures contract from November 22 – 30.
- In the 1st scenario, let's assume that average settlement price for the prompt Brent crude oil futures, for each business day in November is 58.78/BBL. In this case, the price you receive at the wellhead for your November oil production would be approximately $58.78/BBL.
However, because you hedged with the $48.78 swap, you would incur a hedging loss of $10/BBL which equates to net revenue of $48.78/BBL. In this scenario, while you did experience a hedging loss of $10/BBL, the hedge did perform as anticipated and allowed you to lock in a price which was $3.78/BBL more than your budgeted price of $45/BBL.
In the 2nd scenario, let's assume that average settlement price for the prompt Brent crude oil futures, for each business day in November, is $38.78/BBL. As the settlement price is $38.78, you would receive approximately $38.78/BBL for your November crude oil production.
However, due to the fact that you hedged with the $48.78 swap, you would incur a hedging gain of $10/BBL. Similar to the 1st case, your net revenue in this case will be $48.78/BBL as well as the hedging gain offsets the lower, actual price. Once again, the hedge did perform as expected and allowed you to lock in a price of $48.78/BBL or $3.78/BBL more than your budgeted price of $45/BBL.
While this example addresses how oil & gas producers can utilize swaps to hedge their crude oil price risk, a similar methodology can be used to hedge natural gas and NGLs as well. In addition, consumers, marketers and refiners can also utilize swaps to manage their exposure to energy prices as well.