Strip hedging, Stack hedging

[Hend Abuenein]

Hi
I hate it when I have to ask questions from the bottom basics, but here it is:

I don't understand why is it that when an oil producer is in an agreement to supply a certain amount of oil and wants to hedge the risks we are told that he has to LONG future contracts, either in a strip or a stack hedge.

Why LONG when he is an oil PRODUCER?

He owns the underlying commodity, so is long it, so shouldn't he SHORT future contracts as per the supply agreement to lock in a good price ?

Thanks
Hend

 

[David Harper CFA FRM]

Hi Hend,

It's not that basic, it easily confuses (especially as you are surely referring to the Metallgesellshaft). Say you are the oil producer, I am the customer, you will be selling oil to me next year. Two scenarios:

1. (Textbook example) You will sell me one million gallons next year at the future unknown spot price. You are effectively long the future spot price and your hedge is a short future position (so if future spot price is lower than expected, your loss on underlying sale will be offset by profit on the short futures position)

2. Metallgesellshaft's scenario: You promise to sell me (deliver) one million gallon next year at $80.00 per barrel (in their case, the prices were more like $30 - 35). You are now effectively short the future spot price and your hedge is, like MG's, a long futures contract: on the underlying oil, you will be hurt by an unexpected INCREASE in the spot (in MG's case, it was not that it had future deliveries but more specifically that it had committed future delivery at guaranteed prices; this is why in the videos you might notice i actually refer to the UNDERLYING exposures as long-term short position forward contracts [the MG case did not click for me until i realized the underlying exposures were really short forward contracts not plain old future deliveries at unknown spot], which are hedged by short-term long position futures contracts).

I hope that's helpful, David

 

[Hend Abuenein]

Thank you
It was helpful, although I had to read the MG part three times. Very confusing

 

[David Harper CFA FRM]

Hi hend,

I didn't mean to be confusing re: MG. (It sincerely took my ~ 3 years of teaching MG to feel like i understood what happened). Start with this simple idea, that i find a bit wonderful:

Imagine you promise to sell me 100 pounds of coffee next year (Sep 2012). I love coffee so I will be the buyer!

A) If you today promise to sell at $3.00 per pound next, what is your price risk? Your price (market) risk is that the future spot price of coffee goes UP (if higher than $3, you lose the gain)

B) But if you make no promise of the price but only the quantity, what is your price risk? Your risk is that the spot price of coffee goes DOWN!

B) is the case scenario that we study with respect to hedges (i.e., a produces plans to sell in the futures and should use a short hedge), but A) is the MG scenario where they are really short a forward contract

Thanks, David

 

[Hend Abuenein]

I understand the text hedge scenario

But the A scenario you just explained brings this question:

(if higher than $3, you lose the gain)...MG was committed to delivering oil at a certain price, then the spot prices went up. The loss is really what it could've made on the same delivery selling it at the new spot, not the agreement price.
Well... THAT loss was not realized. It's like when you sell a stock at 3 then it goes up. You lost the possibility of a gain, not a realized loss.

If MG were not oil producers, but intermediaries of oil commerce, I would understand that the oil price increase would lead to an increase in their costs of buying the oil to be met by a fixed price of selling it. Which would realize a loss.

But since they are oil producers, and don't have to buy what they're obligated to deliver, where did the losses come from?

 

[David Harper CFA FRM]

Hend,

I absolutely agree with everything you say, this is where MG gets fascinating:

* They did NOT realize losses on these long-term short forward contracts. The opposite: The spot price dropped, such that these delivery promises were winning positions for them.
* Rather, to hedge this risk (the risk that did not materialize, the risk that oil prices would increase), they took LONG positions in short-term futures contracts

Did i somewhere say that actual spot prices went up? If so, i didn't mean that: spot prices went down for MG. (If they had never hedged, they would never have failed!)

So, given they hedged underlying exposure (short forward positions) with long futures contracts, what basically happened is:
* spot price dropped
* forward prices dropped too, but less: shift from backwardation to contango (this i find instructive: the only way that backwardation can become contango is if spot price drop >> forward prices)
* the underlying exposures were economically winning but could not be booked (they weren't marked!) while the hedges were booked for massive losses --> margin calls --> an economically decent/winning position becomes a cash drain b/c only the losing hedge requires current cash

I hope that helps, David

 

[Hend Abuenein]

Wow
I marked this so I can read again when I revise MG
Thanks David

 

[Hend Abuenein]

Hi David,

Q : says a bond portfolio consists of bonds with various maturities. Portfolio manager expects yield curve to become steeper. In that case :
A: A strip hedge will be more effective than a stack hedge.

Explanation : stack hedge is more effective only if yield curve undergoes a parallel move.

1- Please explain why a strip hedge is better than a stack hedge, if a steeper yield curve translates to greater drop in bond prices per point of yield increase.

2- How would the hedge take place?

Thank you in advance.

 

[David Harper CFA FRM]

Hi Hend,

If the underlying portfolio bond has dollar duration of $100 million with various maturities; e.g.,
$10 million @ 5 year duration ($50 mm dollar duration)
+ $5 million @ 10 year duration ($50 mm dollar duration)
= portfolio dollar duration = $100 million

Then, i suppose although "stack" is odd to me in the contact, a stock hedge might be to SHORT a large "stack" of bonds at short-duration; e.g., ~$100 million * 1 year duration.
In this way, we've neutralized delta. But our hedge portfolio in entirely dependent on a parallel yield curve shift; if the 1-year rate doesn't move but the 5 and 10 year rates go up (non parallel), our mistake is exposed: the underlying bonds drop in value but our hedge instruments don't participate in offsetting gains.

The "strip" would be more like matching durations of the hedge instruments, so "key rate" up shift produce offsetting gains on the SHORT hedge instruments. This "strip hedge" is a lot like the whole point of key rate durations; i.e., so the portfolio can handle parallel shifts. Our stack hedge doesn't suffer a parallel up shift b/c it implies the 1-year rate participates.

Hope that helps, thanks, David

 

[zzoujing]

Hi David,

I read this after 5 years it's been posted, and I really want to know why for the stack hedge, the producer has to long a one month future contract equaling the total value of the year's deliveries(assume he signed a contract to deliver oil every month for the next one year), and then in the next month, he again longs a future contract equaling the rest of the deliveries? Can't he long a future contract that equals to his month delivery every month?

Thanks!

 

[David Harper CFA FRM]

Hi @zzoujing

We are assuming a hedge in the (marked to market) price, so as McDonald explains (see below), it's a hedge against the present value of the "stack" of futures contracts; e.g., if you just hedged the next month, you wouldn't be hedged against value drops in the remaining contracts (although they may be unrealized losses). Here is McDonald, I hope this helps:

"Another example of basis risk occurs when hedgers decide to hedge distant obligations with near-term futures. For example, an oil producer might have an obligation to deliver 100,000 barrels per month at a fixed price for a year. The natural way to hedge this obligation would be to buy 100,000 barrels per month, locking in the price and supply on a month-bymonth basis. This is called a strip hedge.We engage in a strip hedge when we hedge a stream of obligations by offsetting each individual obligation with a futures contract matching the maturity and quantity of the obligation. For the oil producer obligated to deliver every month at a fixed price, the hedge would entail buying the appropriate quantity each month, in effect taking a long position in the strip.

An alternative to a strip hedge is a stack hedge. With a stack hedge, we enter into futures contracts with a single maturity, with the number of contracts selected so that changes in the present value of the future obligations are offset by changes in the value of this “stack” of futures contracts. In the context of the oil producer with a monthly delivery obligation, a stack hedge would entail going long 1.2 million barrels using the near-term contract. (Actually, we would want to tail the position and go long fewer than 1.2 million barrels, but we will ignore this.) When the near-term contract matures, we reestablish the stack hedge by going long contracts in the new near month. This process of stacking futures contracts in the near-term contract and rolling over into the new near-term contract is called a stack and roll. If the new near-term futures price is below the expiring near-term price (i.e., there is backwardation), rolling is profitable.

There are at least two reasons for using a stack hedge. First, there is often more trading volume and liquidity in near-term contracts. With many commodities, bid-ask spreads widen with maturity. Thus, a stack hedge may have lower transaction costs than a strip hedge. Second, the manager may wish to speculate on the shape of the forward curve. You might decide that the forward curve looks unusually steep in the early months. If you undertake a stack hedge and the forward curve then flattens, you will have locked in all your oil at the relatively cheap near-term price, and implicitly made gains from not having locked in the relatively high strip prices. However, if the curve becomes steeper, it is possible to lose." -- McDonald, Robert L.. Derivatives Markets (3rd Edition) (Pearson Series in Finance) (Page 187). Pearson HE, Inc.. Kindle Edition.

 

[zzoujing]

Hi David,

Thanks for your reply, it really helped. I think I understand it now that with both strip and stack hedge, the oil producer is hedging all the oil he needs to deliver for the entire year, however, if the oil producer rolls a 100,000-barrel future contract every month, the oils he needs to deliver in the future is not hedged.

Thanks so much!

 

[RaDi7]

Hi David,

please excuse me that I ask you again what Hend Abuenein already asked but I just cannot understand your answers :-(. Could you please explain why in a strip hedge a producer goes long futures contract (not using the MG case but just in general)?

As you explained above it is a hedge against an increasing price but how does it work? If I a were an oil producer I don't need to buy oil so I don't need long futures. What would I do with this supplement oil and my own produced?? For example: I have entered an obligation to deliver oil to 40$ each month for the next year. What price shall I choose in the long future contract I will enter according to strip hedge: also 40$? Would it mean I will have to buy oil to 40$ and then deliver it according to my obligation also to 40$. I this case I don't use my own oil. What will I do with my own produced oil? Store it and wait till the price falls under 40$?

I hope you will find time to answer my question. Thank you very much and have a nice week start!

 

[David Harper CFA FRM]

Hi @RaDi7 Can you review Hull's example, which i have copied below? Notice this concerns an oil producer with (negotiated) plans to sell their oil in the future at the (unknown and unknowable in May) future spot price (in August). Imagine you produce oil and promise to sell me some next year at the future then-prevailing spot price. Maybe it costs you $40 per barrel regardless. You have price risk. Specifically, your risk is a decline in the future spot price; e.g., if the spot price drops to $30, as your cost is 40, you lose. To hedge, you enter a short position in a future contract because, if the spot price does drop, the short future position produces a cash profit that is totally separate from your underyling exposure (hence a hedge implies two positions, the underlying exposure and the hedge instrument. Basis risk requires two positions). Notice that there is a world of difference between, as the oil producer, promising to sell your oil at the future, then-prevailing spot price versus promising to sell at a predetermined price. I hope this helps!

"To provide a more detailed illustration of the operation of a short hedge in a specific situation, we assume that it is May 15 today and that an oil producer has just negotiated a contract to sell 1 million barrels of crude oil. It has been agreed that the price that will apply in the contract is the market price on August 15. The oil producer is therefore in the position where it will gain $10,000 for each 1 cent increase in the price of oil over the next 3 months and lose $10,000 for each 1 cent decrease in the price during this period. Suppose that on May 15 the spot price is $80 per barrel and the crude oil futures price for August delivery is $79 per barrel. Because each futures contract is for the delivery of 1,000 barrels, the company can hedge its exposure by shorting (i.e., selling) 1,000 futures contracts. If the oil producer closes out its position on August 15, the effect of the strategy should be to lock in a price close to $79 per barrel.

To illustrate what might happen, suppose that the spot price on August 15 proves to be $75 per barrel. The company realizes $75 million for the oil under its sales contract. Because August is the delivery month for the futures contract, the futures price on August 15 should be very close to the spot price of $75 on that date. The company therefore gains approximately $79 $75 ¼ $4 per barrel, or $4 million in total from the short futures position. The total amount realized from both the futures position and the sales contract is therefore approximately $79 per barrel, or $79 million in total.

For an alternative outcome, suppose that the price of oil on August 15 proves to be $85 per barrel. The company realizes $85 per barrel for the oil and loses approximately $85 $79 ¼ $6 per barrel on the short futures position. Again, the total amount realized is approximately $79 million. It is easy to see that in all cases the company ends up with approximately $79 million." -- Hull, John C. Options, Futures, and Other Derivatives (9th Edition) (Page 50). Prentice Hall. Kindle Edition.

 

[RaDi7]

Hi @RaDi7 Can you review Hull's example, which i have copied below? Notice this concerns an oil producer with (negotiated) plans to sell their oil in the future at the (unknown and unknowable in May) future spot price (in August). Imagine you produce oil and promise to sell me some next year at the future then-prevailing spot price. Maybe it costs you $40 per barrel regardless. You have price risk. Specifically, your risk is a decline in the future spot price; e.g., if the spot price drops to $30, as your cost is 40, you lose. To hedge, you enter a short position in a future contract because, if the spot price does drop, the short future position produces a cash profit that is totally separate from your underyling exposure (hence a hedge implies two positions, the underlying exposure and the hedge instrument. Basis risk requires two positions). Notice that there is a world of difference between, as the oil producer, promising to sell your oil at the future, then-prevailing spot price versus promising to sell at a predetermined price. I hope this helps!

Hi David,

thank you very much for your explanation! My mistake was that I didn't know that futures are cash settled , so I don't need to take delivery. That was the problem. Thank you very and best regards!

 

[abhinavkhanna]

Hend,

I absolutely agree with everything you say, this is where MG gets fascinating:

* They did NOT realize losses on these long-term short forward contracts. The opposite: The spot price dropped, such that these delivery promises were winning positions for them.
* Rather, to hedge this risk (the risk that did not materialize, the risk that oil prices would increase), they took LONG positions in short-term futures contracts

Did i somewhere say that actual spot prices went up? If so, i didn't mean that: spot prices went down for MG. (If they had never hedged, they would never have failed!)

So, given they hedged underlying exposure (short forward positions) with long futures contracts, what basically happened is:
* spot price dropped
* forward prices dropped too, but less: shift from backwardation to contango (this i find instructive: the only way that backwardation can become contango is if spot price drop >> forward prices)
* the underlying exposures were economically winning but could not be booked (they weren't marked!) while the hedges were booked for massive losses --> margin calls --> an economically decent/winning position becomes a cash drain b/c only the losing hedge requires current cash

I hope that helps, David

Hi David,

Thanks for the clear explanation of Metallgesellschaft case.
As per the above-mentioned points
1. Since the spot prices declined, short long term forward position gained since MG had fixed the price at which the oil was needed to be delivered. It would have received a higher price in comparison to what it would have got if it had promised to deliver the oil at unknown future spot price (In which case the hedge would have been short position in short term futures).
2. But the actual hedge position (long short term futures position) suffered a loss. Since the spot price declined more than the forward price (shift from backwardation to contango) the stack and roll hedge strategy booked massive losses leading to margin calls.
For example: If Spot (January) = $25, Futures (December)= $20 (Backwardation since futures< spot), then after the shift from backwardation to contango after two months Spot (March) = $18 and Futures (December)= $19 (futures price drop< spot price drop), the stack and roll hedge strategy would suffer a loss since the long position would be required to be closed at the end of every month at a loss (since the spot < futures) thereby leading to margin calls.

Please correct me if I am wrong.

Thanks

 

[David Harper CFA FRM]

Hi @abhinavkhanna

1. Yes, exactly, and well put! The underlying (the fundamental) position in the Metallgesellschaft case was the short position in long-term forward oil contracts. They had a forward contract to sell oil at a fixed price in the distant future, say, $30.00, so that if the spot price declined, they profited because they had to pay a lower price to obtain the oil to be delivered.
2. Yes, exactly correct again! Since you understand the basics, a minor addition: it could start with backwardation given by S(Jan) = 25, F(Feb) = 24, F(Mar) = $23.00, F(Dec) = $20 and shift to contango given by S(Feb) = 18, F(Mar) = 18.25, F(Apr) = $18.50 ... F(Dec) = $X. MG employed a stack and roll which tends to be short-dated futures, so the loss here could be something like, albeit our numbers are too dramatic: On January, long a "stack" of the March contract (by) at $23, then next month in February, you'd be offsetting (aka, closing out) those by selling them at lower $18.25. So the loss is blend of declining spot prices and the shift to contango, but if the spot is stable, all you need for the loss is contango. So my additional nuance is that contango is S(0) < F(+1 month) < F(+2 months) < F(+ x months) such that the loss on the roll return due to contango under a stack and roll is due specifically to F(+1 month) < F(+2 months), because you aren't carrying to maturity. And, you mentioned "margin calls" which is very true of the problem: MG had to make margin calls on the losses on the futures contract, but they were not receiving any margin for their gains on the long-term forward calls. There MtM losses were realized in two way (margin and accounting) but their gains were unrealized. Thanks,

 

[abhinavkhanna]

Thanks, David for the explanation.