An analysis of hedging effectiveness for oil consuming entities - does fuel and currency hedging make economic sense?

Abstract

Hedging is one of the most commonly used risk management technique adopted by firms’ treasury departments to mitigate risk exposures, faced by firms across the industries. This research investigates the performance of several oil Futures contracts using WTI and, Brent, and examines the effectiveness of hedging in the oil commodity futures. It also explores the performance of several currency Futures contracts against currency spot prices using three different currencies against the dollar, hence it interprets the causal relation among spot and future prices, however hedging crude oil exposures using oil future contracts must not be considered in isolation since there is also a currency exposure for all entities which do not use the USD as their main currency. Using figures from the financial industry on futures contracts, we can show that hedging is effective in the commodities markets depending on the holding period of the instrument’s future contract. It also depends on the volatility of the price of the underlying instrument’s future contract. The dollar profit and loss was obtained by comparing monthly spot prices with monthly future prices over a 15 year sample period at 3 different time frames. The empirical results highlight that the standard approach to use crude oil future contracts as a hedge is not optimal for time frame (holding periods) of three months or less. By contrast, for longer hedging time frame (holding periods of 4 months), results indicate that crude oil future contracts represent the highest effectiveness in hedging for crude oil spot price exposure. An OLS regression is carried out to test whether a relationship exist between the dollar profit and loss (with results obtained from the analysis described in the preceding sentence) with the OVX index. The results obtained from the regression show that profits are inversely related to, volatility; hence a firm hedging its exposures during a highly volatile crude oil market can end up making losses. As a final point some recommendations are offered that can be adopted to mitigate the risks originating from changing oil prices and unfavourable exchange rates movements.