Commodity Hedging Applications: Producers, Consumers, and Inventory Management

Commodity futures were invented to solve a practical problem: a Kansas wheat farmer planting in May does not know what price they will receive in October. By selling October wheat futures today, the farmer locks in a price and separates the production decision from the pricing risk. This basic structure — natural spot exposure, offset by an opposite futures position — is the template for virtually every commodity hedge.

But commodity hedging has complications that financial-asset hedging does not. The commodity available for delivery may differ from the commodity underlying the futures contract (cross hedging). The hedge may need to extend further than the most liquid futures maturity (stack-and-roll). The forward curve shape determines whether rolling costs money (contango) or earns money (backwardation). And the Metallgesellschaft disaster shows that even a theoretically sound hedge can fail if cash flow timing is not managed.

• set up a short hedge for a commodity producer and a long hedge for a commodity consumer;
• apply the minimum-variance hedge ratio to a cross-hedge situation;
• compute the optimal number of commodity futures contracts given the exposure quantity and contract size;
• explain the stack-and-roll mechanism and identify the liquidity risk it introduces;
• summarise the Metallgesellschaft case and draw the generalised lesson for long-dated commodity hedges;
• describe the crush spread and crack spread hedges.

1. Short hedges for producers
2. Long hedges for consumers
3. Cross hedging: the airline jet fuel problem
4. The crush spread and crack spread hedges
5. The stack-and-roll hedge
6. Metallgesellschaft: the $1.33 billion lesson