Given how difficult is to accurately predict price moves in commodities, it's perfectly understandable that those whose livelihoods depend on commodity prices use hedging to obtain some degree of certainty over the viability of their business in the future.
A Simple Example
A farmer in Kansas is due to produce 10,000 bushels of corn this harvest. Her costs for machinery, labor, water, fertilizers, energy, interest on loans and her own salary amount to approximately 20,000 dollars for the season. If she therefore earns less than this from the upcoming harvest, she will have to fill the gap from savings. If September delivery corn is trading at 4 dollars per bushel on the Chicago Board of Trade, what should she do?
The farmer's options
The contract size for CBOT corn is 5,000 bushels, giving our farmer 2 real potential hedging trades.
Scenario 1) She could hedge the entirety of her production at 4 dollars by selling 2 contracts. This would generate a revenue of 40,000 dollars, and locking in a 20,000 dollar profit for her season's work.
Scenario 2) Alternatively she could only sell 1 contract. This would lock in a revenue of 20,000 dollars for half her crop, ensuring that she can pay her costs, while remaining at risk for the other half.
Accounting for the hedge
Price of Corn Falls to 3 dollars:
Scenario 1)
Profit on Hedge= 10,000 x (4-3) = 10,000
Revenue from Corn Sales = 10,000 x 3 = 30,000
Total Revenue = 40,000 USD
Scenario 2)
Profit on Hedge= 5,000 x (4-3) = 5,000
Revenue from Corn Sales = 10,000 x 3 = 30,000
Total Revenue = 35,000 USD
Price of Corn Rises to 5:
Scenario 1)
Profit on Hedge= 10,000 x (4-5) = -10,000
Revenue from Corn Sales = 10,000 x 5 = 50,000
Total Revenue = 40,000 USD
Scenario 2)
Profit on Hedge= 5,000 x (4-5) = -5,000
Revenue from Corn Sales = 10,000 x 5 = 50,000
Total Revenue = 45,000 USD
The Risks
Opportunity cost: In option 1 above, while our farmer guarantees a modest profit for the upcoming crop, what happens if the price of corn rises to 6 dollars per bushel? All our farmer's neighbors that didn't hedge will be making double the profit (per bushel), leaving our farmer feeling left out. We all understand FOMO (fear of missing out) and in this case it can be a powerful motivator. Very often producers of commodities will not be big hedgers - they will want to participate in big price rises more than they want to lock in modest gains.
Margin calls: One of the very often overlooked complications of hedging is the associated margin calls. When you trade commodity futures, you have to put up very little cash to begin with - you can buy 5,000 bushels of corn at 4 dollars without having to put up 20,000 dollars up front. However, you have to post cash if the position moves against you - this is called variation margin. So in our examples above where the price rose after hedging, our farmer would have to transfer 5,000 or 10,000 dollars to her broker in order to fund the losses on the futures. Even though she will realize the gains from selling her corn in the physical market once harvested, in the meantime she might have a problem. This means that in order to hedge, our farmer needs to have substantial cash savings sitting in an account to pay margin calls.
Basis: This is a key concept in physical trading that we've covered in other posts but deserves being repeated. Physical commodities always have subtle differences that merit a price difference from the futures price or benchmark. This could be quality, location, or even moisture content of the specific container. If our farmer's neighbors have a bumper crop, prices in her corner of the world might drop relative to the futures price, rendering a portion of the hedge redundant. Similarly, if she managed to overcome bad weather in the region and produce on target, she may benefit from receiving a premium for her corn. t is in general very hard to hedge basis - the risks are idiosyncratic to particular regions or types of material that aren't covered by futures contracts.
Performance Risk: This really refers to the awful scenario in which the crop is somehow damaged and our farmer can't produce her anticipated 10,000 bushels. If she has hedged and is down 10,000 dollars in margin calls, and can't produce the goods, it can be financially very disruptive.
While superficially hedging seems like the prudent course of action, we can see now that it isn't quite that simple. For smaller producers, hedging can seem like a minefield ridden with opportunity costs, and tying up cash that could end very badly if there is any problem in the production process.