How Do Crude Oil Futures Lock Prices and Options Provide a Safety Net? Practical Derivatives Use in Crude Oil Investment

TradingKey - In the crude oil market, prices are highly volatile. Oil-related companies—such as upstream producers, downstream refiners, or midstream traders—rely on derivative instruments to hedge risks and lock in profits.

So, under what circumstances would these companies choose options or futures? And what lessons can individual investors learn from them?

How are futures contracts used for hedging in crude oil investment? How can they protect you?

Oil Producers: How to Manage the Risk of Falling Prices?

For oil producers, a drop in oil prices can directly impact revenue.

To mitigate this risk, companies can use short positions in futures contracts to hedge.

For example:

Suppose an oil company expects to produce and sell 1 million barrels of crude oil in three months, and the current spot price is $70 per barrel.

The company enters into a short futures position of 1,000 contracts—each covering 1,000 barrels—at a settlement price of $72 per barrel, with maturity set for three months, to secure future revenue.

After three months, the market price had dropped to $65 per barrel. Although the company earns less from the physical sale, the gain in the futures market offsets this loss:

(72 - 65) × 1,000 × 1,000 = $7 million profit.

Therefore, hedging with futures acts like an "insurance policy," helping companies reduce losses when prices fall.

(Source: Freepik)

Oil-Consuming Enterprises: How to Manage the Risk of Rising Prices?

For oil-consuming enterprises such as refineries and airlines, rising oil prices increase operating costs.

To stabilize procurement costs, they can hedge by buying futures contracts.

Let’s look at another example:

A refinery anticipates acquiring 500,000 barrels of crude oil within two months, with the prevailing spot market price at $68 per barrel.

To lock in costs, the refinery buys 500 futures contracts (each representing 1,000 barrels) maturing in two months at $70 per barrel.

At the end of the two-month period, the price increased to $75 per barrel. Although the cost of purchasing oil in the physical market increases, the gain in the futures market offsets part of this loss:

(75 - 70) × 500 × 1,000 = $2.5 million profit.

• Buying Call Options: How to Capitalize on Rising Prices?

If you anticipate a rise in crude oil prices, you can purchase a call option to control risk while capturing gains from price increases.

For example:

Suppose you buy a crude oil call option with a strike price of $70 per barrel at a premium of $3 per barrel (each contract covers 1,000 barrels). If prices rise to $80, you can exercise the option to buy oil at $70 and immediately sell it at the market price of $80.

Even if prices don’t rise, your maximum loss is limited to the premium paid.

Buying a call option is like a "limited-risk bet"—ideal for investors confident about price increases.

• Buying Put Options: How to Hedge Against Falling Prices?

An investor purchases a crude oil put option with an exercise price of $65 per barrel, paying a premium of $2 per barrel.

If prices drop to $55, you can exercise the option to sell oil at $65, avoiding larger losses.

Thus, buying a put option effectively locks in a minimum value for your position.

Options are equally applicable to oil companies:

For downstream enterprises (e.g., refineries or airlines), rising oil prices directly increase raw material costs. To mitigate this risk, they can buy call options to lock in future procurement costs.

For upstream producers, falling prices directly impact sales revenue and profits. To address this risk, they can buy put options to secure future selling prices.

Midstream traders face risks from both rising and falling prices, so they often use option combinations to confine price volatility within a specific range.

(Source: Freepik)

A swap is a bilateral financial contract involving the periodic exchange of cash flows tied to an underlying asset over a pre-defined term.

In the oil sector, this typically involves the exchange of cash flows based on oil prices.

For example, an oil production company might be concerned about falling oil prices impacting its revenue, while a refinery might worry that rising oil prices will increase its costs. Therefore, they enter into a swap agreement:

• The oil production company pays the refinery cash flows based on a fixed price.
• The refinery pays the oil production company cash flows based on fluctuating market prices for crude oil.

This approach enables the oil producer to fix future income and mitigate exposure to potential price declines. Meanwhile, the refinery can stabilize its raw material costs and hedge against rising oil prices.

Thus, swaps act like a "customized balancing tool," catering to the risk management needs of different businesses.

What Are the Risks Associated with Swaps?

The primary risk associated with swaps arises from counterparty credit risk.

Counterparty default could result in financial losses for the non-defaulting party.

In the previous example, if the oil production company commits to paying fixed cash flows under the swap agreement but later fails to fulfill its obligations due to poor financial performance, the refinery would incur losses as a result.

As such, swaps are typically conducted between financial institutions and large companies and require strict credit assessments and legal safeguards.