[jiji]

On November 1, Year 1, XYZ Company forecasts production of 10,000 barrels of oil in January of Year 2. Oil is currently selling for $85 per barrel. To hedge the risk that the price of oil will decrease before the oil is sold, XYZ takes a short position in a forward contract for 10,000 barrels of oil at $85 per barrel to be settled on January 31, Year 2. The forward contract requires net settlement, rather than the actual delivery of oil. The oil is sold on February 1 for $71 per barrel. XYZ classifies the hedge as a cash flow hedge of the anticipated change in cash flows from the forecast oil sales. Relevant forward contract prices are as follows:

Oil/Barrel Forward

November 1, Year 1 $85.00

December 31, Year 1 $79.00

January 31, Year 2 $71.00

xyz sold the oil with less revenue but why it’s a gain on the hedge?

[Nessie]

They made money because they took a “short” position. Think of the bulls and bears comparison. Bullish means you think something will go up, Being bearish means you think something will go down. Hedging is sort of like taking the opposite position to protect one’s self if the opposite occurs.

By taking a short position with the forward, they were taking a bearish position. When it came time to settling up, the underlying had dropped in value, so to settle up took much less $$ (even though they didn’t settle with oil in the forward contract).

They were bullish in the actual production of oil- obviously, or they would not be producing it, but with the derivative, they took the opposite outlook as an insurance policy.

I think what confused you was “short” rather than just buying or going “long” with the forward contract. It turns out the forward made money, but the oil production part of the business took a loss.

REG Aug 20/15: 88
AUD: Feb 29/16: 80
FAR: Jun 10/16: 80
BEC?

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[jiji]

Nessie, Thank you so much! Great explanation.

[Excel14]

Simply put, you entered a contract to sell the oil at $85, so when the price dropped to $71, your $14 gain on the hedge, completely protected the cash flow lost when you actually sold the oil for $71. Remember too, that the effective portion of the cash flow hedge goes into OCI too (as of 12/31, the difference between $85 & $79), and not into earnings until 02/01 of the following year when the oil is sold. You then move the OCI gain to the income statement.

BEC (2/28/16) ----- 78
FAR (09/10/16)-----
AUD
REG

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[Author]

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