Oil Hedging Strategies Using Futures and Options: Applications for the State of Alaska

Abstract

ABSTRACT The continued decline in the price of oil and increased uncertainty about future revenues have caused severe budgetary constraints for oil companies and for states dependent on oil revenue. Using the futures market to hedge against adverse price changes is becoming an important tool in the oil industry to establish future dollar income figures. An additional hedging tool, options on crude oil futures, began trading on an organized exchange in November, 1986. Like other options, they offer a means of buying insurance against a potential price decrease. This paper describes the possibilities of risk reduction that are available through crude oil futures contracts and the new options on crude oil futures contracts, and examines the case for the state of Alaska. Basis risk, the key variable based cn the relationship between cash and futures prices, is calculated for Alaska North Slope oil and the results are interpreted to judge hedging strategies for Alaska. A variation of traditional hedging, called Exchange of Futures for Physicals (EFP), is also presented as an alternative hedging plan.