Mark Sullivan

FIN 622 Partial Hedge

By Mark S Sullivan

Example is derived from test.
The use of a partial hedge by the oil industry to cover the risk of meeting the fixed costs of the business in the volatile pricing market.
Assume that an oil company produces 1,000,000 barrels of oil per year. The cost of extracting this oil is $17 per barrel. The company has overhead fixed costs of $1,000,000 and an interest expense of $1,000,000. The company has the opportunity to hedge it’s production at $86 per barrel, how much should it hedge.

The total $ that the company must cover are $1 million in fixed costs, $1 million in Interest and $17 million in production costs. This is a total of $19 million, in short the company has produced 1 million barrels of oil for a cost of $19 million.
To hedge production for the company to ensure that it can meet it’s commitment then the company need only hedge enough oil to meet the $19 million. Thus $19 million divided by $86 (value of the forward sale) leads to a hedge position of forward selling 220,930 barrels of oil.
This leaves the company with 779,070 barrels of oil that it can sell at spot.

Barrels of production 1,000,000
Fixed Cost $1,000,000
Interest Cost $1,000,000
Extraction Cost $17 * 1,000,000 barrels $17,000,000
Total costs $19,000,000

Hedge Size $19m / $86 per barrel 220,930
Forward price $86
Total Sales $86 * 220,930 barrels $19,000,000

The firm has produced 1,000,000
The firm has forward sold 220,930
The firm has available for sale at spot 779,070