Risk Management 101: Part 2

Sep 26, 2023 | Uncategorized

We’re discussing what market risk is, how it’s in every producer’s life, and how to better understand Risk Management (RM) to improve our chances of success.

Earlier, ESP Devin Patton, introduced futures contracts (if you missed it, here’s the link.) This week, he’s focusing on helping us understand Long Hedging.

Here goes:

Short hedging is done when the operator produces or otherwise owns the physical commodity (Long) and they would be taking an opposing short position as a substitute for a sale.

Long hedging occurs when the operator uses the commodity and needs to purchase more of it in the future.

Examples of this could be an ethanol plant, flour mill, or a cattle feedlot.

Cattle feedlots purchase light cattle and feed and sell bigger cattle. So, they might have an interest in Long hedging future purchases of feeder cattle and corn, and then short hedging Live Cattle contracts further out.

Once they make their physical purchases, they would lift their long hedges or possibly roll them forward again for future purchases, unless they deem, they are more comfortable carrying the risk in the cash market.

For a long hedger, taking a long position means that they transfer their risk from being cash “short” (or in need) to market neutral. Since they would rather pay less for something than more for it, they want to protect from rising market prices. 

They buy futures contracts (remember last week) that will offset their increased cost of future purchases if the market rises, and likewise their lower costs to purchase in a decreasing market will be offset by losses on their long hedge.

This is to create certainty of costs for materials in the future. Even if they would have been better off after a market decline, increasing certainty is worth accepting that risk in exchange for eliminating the risk of added cost from a rising market. 

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