What Is a Legacy Hedge?
- A legacy hedge is a hedge position, often a futures contract, that a company has held for a long time.
- Commodity companies often hold legacy hedges on their reserves.
- Legacy hedges are a way for commodity companies to guarantee a return on the sale of a commodity far into the future.
- When futures contracts expire, if the spot price has increased, the company ends up selling the commodity below current market value; if the spot price has decreased, the company sells above market value.
Understanding Legacy Hedges
A legacy hedge is a way for a commodity company to guarantee a return on the sale of a commodity far into the future. Some commodities, such as oil or precious metals, experience frequent shifts in market price.
To stabilize their revenue streams, they may hedge against price volatility by signing a futures contract, an agreement to sell a commodity on a specified date at a specified price. They effectively lock in the spot price of the commodity at the time they sign the contract.
For the amount of the commodity in the legacy hedge, the company has given up any potential gains from a price increase in exchange for protection against potential losses from a price drop.
While the commodity company would welcome the extra profits from rising prices, guaranteed compensation may be more valuable as it allows the company to make management decisions based on a stable future income stream.
Pros and Cons of Legacy Hedges
Any hedge position can cut both ways. If the spot price has increased by the time the futures contract expires, the company will end up selling the commodity below current market value. If the spot price has decreased, the company will be selling above market value.
As a long-held hedge position, a legacy hedge can have an especially dramatic stabilizing, particularly if a fundamental shift in market forces affecting the commodity occurs in the meantime.
For example, any gold producer who signed a 10-year futures contract in 2001, locked in the spot price when gold was trading at less than $300 per troy ounce. Before the contract expired, the US housing market crashed and the global economy suffered the Great Recession.
The price of gold skyrocketed as the stock market collapsed and faith in the US dollar faltered internationally. In 2011, when the contract would have expired, gold prices climbed as high as $1,889.70 per troy ounce. Any gold tied up in the futures contract did not deliver to the gold producer the benefit of the more than 500% increase in price over the 10-year period.
While gold prices have since gone up and down, as of late 2020, they remain significantly higher than pre-Great Recession prices, so any gold producer still sitting on legacy hedges established before gold prices shifted upward is sitting on losses.