How Farmers and Airlines Hedge With Futures

Farmers hedge by selling futures before harvest, so a fall in crop prices is offset by a gain on the futures. Airlines hedge by buying futures (or related contracts) on fuel, so a rise in fuel costs is offset by a gain on the futures. Both give up some of the benefit if prices move in their favour.

In short: A grain or oilseed producer uses a short hedge to lock in an approximate selling price; a fuel buyer uses a long hedge to lock in an approximate purchase price. Farmers usually hedge the exact commodity they grow. Airlines usually cannot, because there is no widely traded jet fuel futures contract with the liquidity of crude oil or diesel, so they “cross-hedge” with a related contract and accept extra basis risk. History shows that both kinds of hedgers can get hurt when they hedge too much, too far ahead, or without the cash to meet margin calls.

The general mechanics (short and long hedges, basis, hedge ratios) are explained in how hedging with futures works. This article applies them to two real kinds of business.

Part 1: a canola grower in Saskatchewan

Canola futures trade on ICE Futures U.S. and are priced in Canadian dollars. The real contract specs:

Spec	ICE canola futures
Contract size	20 metric tonnes
Price quote	Canadian dollars per tonne
Minimum tick	C$0.10 per tonne = C$2.00 per contract
Delivery	Par region in Saskatchewan

More on crop contracts and calendars is in agricultural futures explained.

The plan

In spring, a grower expects to sell 400 tonnes of canola after the fall harvest. The November futures contract trades at C$650 per tonne (illustrative). From past years, the grower expects the local delivered price at harvest to be about C$20 under November futures, a basis of -C$20.

• Expected net price: C$650 + (-C$20) = C$630 per tonne
• Contracts: 400 / 20 = 20 contracts, sold

Harvest, prices lower

At harvest, November futures have fallen to C$600, and the local buyer bids C$575. The basis is -C$25, C$5 weaker than expected.

	Calculation	Result
Cash sale	400 t x C$575	C$230,000
Futures gain	(C$650 - C$600) x 400 t	+C$20,000
Total		C$250,000
Net per tonne	C$250,000 / 400	C$625

In ticks: a C$50 move is 500 ticks, times C$2.00 = C$1,000 per contract, times 20 = C$20,000. The C$5 shortfall from the C$630 target is the basis surprise: -C$5 x 400 = -C$2,000.

If prices had risen instead, the grower would have lost on the futures and earned more on the cash sale, landing at roughly the same C$625. Without the hedge, the grower would have received only C$575 in the falling-price case.

How farmers actually do it

Many producers never touch a futures account. They sign a forward contract with an elevator or crusher, fixing a price for future delivery. The buyer then hedges on the exchange. Others use basis contracts, hedge-to-arrive contracts, or options. The differences between exchange futures and private forward deals are in futures vs forwards.

Most producers also hedge only part of expected output. Yield is uncertain, and hedging a crop you never harvest leaves a naked futures position.

Part 2: an airline buying jet fuel

Jet fuel is one of an airline’s largest costs. The trouble for hedgers is that the most liquid fuel futures are crude oil (WTI and Brent) and NY Harbor ULSD (ultra-low sulfur diesel). Jet fuel is a distillate like diesel, so the prices are related, but they are not the same.

The real NYMEX NY Harbor ULSD contract (symbol HO):

Spec	NY Harbor ULSD futures
Contract size	42,000 gallons (1,000 barrels)
Price quote	Dollars per gallon
Minimum tick	$0.0001 per gallon = $4.20 per contract

The plan

An airline expects to buy 4,200,000 gallons of jet fuel in three months. One-for-one, that is 100 ULSD contracts. Using historical data, its risk team estimates a hedge ratio of 0.9 (jet fuel and diesel are highly correlated but the futures tend to move slightly more), so it buys 90 contracts.

Illustrative prices at the start: ULSD futures $2.50 per gallon, jet fuel $2.60 per gallon (a jet-minus-ULSD spread of $0.10).

Three months later, prices higher

ULSD futures are $3.00 and jet fuel is $3.15. The jet-ULSD spread widened to $0.15.

	Calculation	Result
Fuel bill	4,200,000 gal x $3.15	$13,230,000
Less futures gain	($3.00 - $2.50) x 42,000 x 90	-$1,890,000
Net cost		$11,340,000
Effective price	$11,340,000 / 4,200,000	$2.70 per gallon

In ticks: 50 cents is 5,000 ticks, times $4.20 = $21,000 per contract, times 90 = $1,890,000.

The unhedged price would have been $3.15. The hedge did not get the airline back to $2.60 for two reasons: the jet-ULSD spread widened (basis risk) and the airline hedged at a 0.9 ratio.

Three months later, prices lower

Now suppose ULSD falls to $2.00 and jet fuel to $2.08.

	Calculation	Result
Fuel bill	4,200,000 gal x $2.08	$8,736,000
Plus futures loss	($2.50 - $2.00) x 42,000 x 90	+$1,890,000
Net cost		$10,626,000
Effective price		$2.53 per gallon

An unhedged competitor pays $2.08. The hedged airline pays $2.53. In a market where ticket prices follow fuel costs down, that gap is a real competitive disadvantage, and it shows up in the airline’s results as hedging losses.

Airlines also use swaps, options, and collars in the over-the-counter market, often written directly on jet fuel. Those reduce basis risk but add counterparty risk and collateral agreements.

What went wrong historically

Farmers: the hedge-to-arrive crisis of 1995-96

A hedge-to-arrive (HTA) contract let a farmer fix the futures part of the price with an elevator while leaving the basis to be set later. Some versions also let the farmer “roll” the contract forward to a later delivery month, or even a later crop year.

In 1995 and 1996 corn prices rose sharply. The CFTC’s FY 1996 annual report noted that corn and wheat prices climbed “to historically high levels” and that record corn prices “exacerbated problems with ‘hedge-to-arrive’ contracts.” Many farmers had committed more than one year’s crop and kept rolling. The market was inverted (later months priced below nearby months, known as backwardation, explained in contango and backwardation), so every roll from an expensive nearby month into a cheaper deferred month locked in a further loss.

The elevators that had hedged these contracts on the exchange faced large margin calls, and some ran into financial difficulty. Farmers who had agreed to deliver corn they had not yet grown faced demands for payment. On May 15, 1996 the CFTC staff issued policy statements and guidance on HTA contracts, and lawsuits followed in several states. The lessons: do not hedge more than you will produce, be wary of rolling across crop years, and remember that the elevator’s margin problem can become yours.

Airlines: hedges that work until they don’t

Southwest Airlines is the best-known fuel hedger. Its 2008 annual report said its fuel hedges “contributed to cash savings of almost $1.3 billion during 2008,” as oil spiked to record highs that summer.

The same report shows the other side. When oil collapsed in the second half of 2008, the value of Southwest’s hedges for future years swung sharply. At December 31, 2008, the fair value of its outstanding fuel derivatives was a net liability of $992 million. The company said it had “significantly reduced its hedge in order to minimize fuel hedging losses” and to limit the cash collateral it might have to post to counterparties, cutting its hedge to roughly ten percent of expected fuel purchases for 2009 through 2013. Its third quarter 2008 results included $247 million in special charges, mainly mark-to-market adjustments on hedges for future periods, producing a quarterly net loss of $120 million.

When oil fell again from late 2014, airlines that had hedged at higher prices, including Southwest, reported hedging losses that added significantly to fuel expense in 2015 and 2016, while unhedged rivals enjoyed the full drop.

None of this means hedging was a mistake. It means a hedge program is a policy decision about how much volatility the business can tolerate, and it has to be judged over full price cycles, with enough liquidity behind it to survive collateral calls.

What can go wrong: a checklist

• Basis risk: local cash prices or jet fuel spreads can move against you even when futures behave.
• Quantity risk: a smaller harvest or fewer flights leaves part of the hedge unmatched.
• Margin and collateral: a hedge that is right in the long run can still demand large cash payments in the short run.
• Rolling losses: long-dated hedges built from short-dated contracts are exposed to the shape of the curve.
• Competitive risk: if your competitors are unhedged and prices fall, your costs are higher than theirs.
• Counterparty risk: off-exchange swaps and forward contracts depend on the other side paying.

The short version

A canola grower sells futures to protect a harvest price and ends up near the futures price plus the local basis. An airline buys diesel or crude futures to protect a fuel budget and ends up near its target, give or take the gap between jet fuel and the contract it used. The hedge-to-arrive crisis of 1995-96 and airline hedging swings in 2008 and 2015-16 show the same lessons from both directions: match the hedge to real exposure, plan for margin calls, and judge a hedge by how the whole business performed, not by the futures line alone.

Related: How hedging with futures works · Crude oil futures explained · Agricultural futures explained