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I'm new to this stuff, and have the following question:

In John C. Hulls book the following scenario is presented: on May 15 we enter into a contract to sell 1 mill barrels of oil for the market price on August 15. The oil future expiring on that day are 79 dollars. We can hedge our position by selling 1000 contracts (for 1000 barrels each), and closing them out near August 15. It is then easy to see that in all cases we get 79 million in total (for the contract + the futures)

Now my question is, why did we enter into the contract in the first place? It seems much simpler to just sell 1000 future contracts and not close the position, but just let them expire. Then we still get our 79 million in the end.

A related question: in practice, can a position always just be closed without problems? Is there not a significant risk of not finding a counter party to close the position and being stuck with the futures?

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  • $\begingroup$ You will always find a counterparty, the question is: at what price :) $\endgroup$
    – amdopt
    Jun 9 at 13:27
  • $\begingroup$ Could you take us through the details in each scenario, please? $\endgroup$ Jun 12 at 22:45
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I think you're misinterpreting the scenario. The initial contract is not a futures contract but a spot purchase contract.

why did we enter into the contract in the first place?

Imagine that you are an oil producer in North Dakota and have a contract to sell oil to a refinery in Minnesota on Aug 15th at whatever the spot market price is on Aug 15th. If you enter into a short CME futures contract instead, you'd have to deliver the oil to Cushing, Oklahoma instead of the refinery. So you enter into a spot contract with the refinery instead.

Is there not a significant risk of not finding a counter party to close the position and being stuck with the futures?

Not in a highly liquid exchange-traded commodity like oil. There are market makers that will help you get out of these contracts at (close to) current market prices.

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  • $\begingroup$ I understand the scenario, but my question is: by hedging in this way, we essentially guarantee ourselves that we walk away with 1000*(spot price on aug 15). We can also get the guarantee by just selling the futures, and not entering into the initial contract. So why did we enter into the contract? $\endgroup$ Jun 9 at 13:36
  • $\begingroup$ Probably because you have (or are producing) 1,000 of physical oil to sell and don't want to have to transport it to Cushing, Oklahoma to sell on the exchange. What if the price drops to \$1 on Aug 15? Wouldn't you rather lock in a price of \$79? $\endgroup$
    – D Stanley
    Jun 9 at 13:38
  • $\begingroup$ But if we sold 1000 fututes at 79 dollars in May, we also locked in the 79/barrel, so either way we would get our money, with or without the contract. But I get your point about the delivery $\endgroup$ Jun 9 at 13:40
  • $\begingroup$ Yes that's the difference. With futures you are required to deliver at a specific location. $\endgroup$
    – D Stanley
    Jun 9 at 13:41
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    $\begingroup$ True, buyers of physically delivered oil are a smaller group, but there's plenty of pipelines out of cushing and transport companies to make it viable, but I am not an expert on the details of the supply chain. The hedging/speculation market is much larger though I believe. $\endgroup$
    – D Stanley
    Jun 9 at 18:28
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I have not read this book now but I am assuming this:

  • On May 15 we enter into a contract to sell 1 mill barrels of oil (I assume that is a producer who negotiates a contract with someone and agrees to take the price on August 15th?)
  • So the future is to hedge this agreement (producer has risk that price is low). If you do not get rid of it (and have WTI future), you actually have the problem of 1000*1000 barrels of oil - Delivery procedure
  • With regards to the follow up question: you cannot be sure to always be able to do it easily, which is what happened last year in an extreme scenario.
  • That is not an issue with cash settled contracts which is why Brent never actually got close to 0 or negative
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  • $\begingroup$ Thanks, so the value of entering into the intial contract is that the delivery conditions of the future are more annoying/costly then the delivery condition that we agreed upon in the contract? $\endgroup$ Jun 9 at 13:36
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Some petroleum futures (e.g. Western Texas Intermediate - WTI) are physically settled. if you don't close out the position before expiry, they you will have to physically deliver (or take delivery) in Cushing, Oklahoma.

However some other petroleum futures (e.g. Brent) are cash settled. If you don't close out the position, you won't need to deal with physical delivery at expiry.

Yes, there is a small risk that if you try to trade a futures shortly before expiry, there would not be enough interested counterparties. That's what happened in April 2020 with WTI futures. That did not mean that you could not find a counterparty - you still readily could, just the prices were not what the sellers wanted. I don't think this can happen to cash-settled futures though.

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