The hedging efficiency of crude oil markets: OIES paper: M20

This paper considers the measurement of hedging efficiency. It is argued that conventional measures of the efficiency of risk management operations my be unreliable in commodities where the available hedge represents the value of the commodity for forward, rather than prompt, delivery. Considerable biases can arise when the time structure of prices is not considered, which tend to lead to overstatement of the efficiency of the hedging vehicle. As an alternative we propose the use of simulations of hedges. The use of simulations not only produces very different results to standard financial formulae, but also demonstrates the sensitivity of the effectiveness of hedging to the time structure of prices. This produces some direct inferences for optimal hedging behaviour. Our simulations consider how effective crude oil futures are for the hedging of various streams of tradeable crude oil. The futures contracts, used alone in a hedging strategy, are shown to perform unpredictably in the hedging of dated Brent, which is the direct price index for some 16 million barrels per day of crude oil trade, and whose influence, particularly in the Far East, is still expanding. We contend that the reason for this poor hedging performance is the non-randomness of the basis risk between futures and prompt crude oil. This basis tends to trend, and we consider hedging effectiveness in three regimes, contangos and both narrowing and widening backwardations. We find that the hedging effectiveness is highly dependent on the time structure regime. Because of the potential size and volatility of the basis, under some conditions using futures as a hedging instrument can produce more risk than unhedged positions. This also has implications for market structure, with the development of informal markets to help hedge the risk that can not be hedged by the use of the futures. The implication of our analysis is that the potential gains are considerable for futures market users who are unable, or unwilling, to access the subsidiary informal markets, should a futures contract whose value more closely proxies that of dated Brent be available