Help me understand hedging...

[simple tradist 0]

Question: If, hypothetically, a E&P has hedged production of 100,000 barrels with a ceiling of $65 and crude goes to $100 does that company just have to eat the loss of $35 a barrel or are they able to switch out their hedges?

[0R0 + 6,251]

Depends how they did it.

If they shorted futures then yes, they are on the hook for the difference. Under current backwardation conditions that is doubly risky because the the future will go up as it approaches maturity - at least till the market is well supplied again and contango appears.

If they bought puts then they are clear, but then puts are expensive and will eat a good chunk of the price. 

Then they can sell calls, which leaves them still on the hook, or call spreads, which limits potential losses. 

Finally is a forward sale at the fixed price to a final buyer like a refiner rather than the futures market. The terms for that can be anything. But usually in the case of backwardation, the forward delivery contract will get only a modest premium to the futures price for the delivery window. Using a trading house gives you more flexibility to tailor your contract to your needs but will cost you.

[Zhong Lu + 845]

Don't bother hedging.  If not comfortable, just sell.  Can always buy back later.  

Hedging only works if you're dealing with billions of dollars, when you can't sell because of liquidity issues.  

Edited January 8, 2020 by Zhong Lu