Many companies rely on the ability to manage the risk caused by fluctuating commodity prices in the marketplace. These companies can use the futures markets to effectively secure acquisition prices in commodities such as oil and gas and ensure a fixed profit margin.
Consider for example an airline that wants to capitalize on low crude oil prices. Crude oil is the source of jet fuel, and rising crude oil prices pose a risk to the profits of the airline. The airline can manage the risk of rising oil prices by entering into a long hedge in the futures market.
Let's assume that it does so and buys New York Mercantile Exchange (NYMEX) crude oil futures. In doing so, if the price of crude oil rises, the airline will make a profit from their long position, offsetting the increased expense to the business of higher fuel prices.
Similarly, low gasoline prices can be locked in using a long hedge in NYMEX RBOB gasoline futures. In this case we can imagine a trucking company that wants to lock in low gasoline prices and hedge against rising prices. By buying gasoline futures the company would profit from a rise in gas prices, offsetting the additional cost to the business from higher gasoline prices.
Both of these examples are long hedges in which companies secure the price of a commodity used in the operation of the business.
Conversely, a company might enter into a short hedge to protect the value of holdings of a certain commodity. For example, an oil producer could hedge against the risk of falling oil prices by short selling crude oil futures.
Here, in the event of falling prices, the company balances the loss in value of its inventory with profits from the short position in the futures market.
The Bottom Line
The futures markets are made up of hedgers and speculators. Speculators assume the risk that hedgers are looking to offset and provide liquidity to the market. Derivatives such as commodity futures are increasingly important in global markets as a tool for effectively managing risk.