Commodity Short Hedge

[Dibbs]

Hi guys,

I've got a basic question about commodity futures and producers. I've read this article : FT Press: Basic Training: A Futures Primer > A hedging example which has got me a bit confused.

I thought that commodity future were settled with the future. From what i've been reading in the first example of the site i've given, is that, a producer who wants to hedge his production will enter into a short hedge (sell a future contract), and at expiration, he will sell his production and buy back his future contract in the open.

I thought that producers usually delivered their product through their future position. (And not by closing their future position, then, selling @ mkt price).

Am I missing something ? Thanks!

 

[Joy Pathak]

If I get what you're asking is that are futures delivered or settled? I didn't read your example in detail.

Futures are mostly settled financially. There are some deliveries, but that depends. It is not cost effective for a producer in California to ship to Ohio. He/she will sell his/her product locally to save those costs and just close out the hedge before delivery date. Financial settled contracts of this sort basically reduce the overhead costs.

I think only 1% actually goto physical delivery. Before delivery date, the trader gets several notices. Traders have to offset their contracts before the expiration. The key is to not hold the position to experiration.

There are usually a "financial settlement" contract and a "Delivery" contract, e.g types of WTI contracts. But that just for ease to give non-producers(pension funds, etc) the chance to trade because they could never make a physical delivery.

 

[Dibbs]

Thanks, thats the kind of answer I was looking for.