New York Harbor Unleaded Gasoline

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The American motorist may well remember the first indications of price volatility in the gasoline market, when prices at the pump skyrocketed following the Yom Kippur War of 1973. Oil supply disruptions occurred again in 1979, when the fall of the Shah of Iran sent gasoline prices climbing sharply. Gasoline prices and allocation controls in effect at the time had the perverse effect of generally keeping prices higher than market-clearing levels. Controls were removed in early 1981, and the NYMEX Division New York Harbor leaded gasoline futures contract was introduced soon after, giving gasoline refiners, marketers, and large consumers a method of managing their price risk for the first time.

Gasoline is the largest single volume refined petroleum product sold in the United States, and accounts for approximately half of the nation's oil consumption. In 1995, total U.S. gasoline consumption was 119 billion gallons, sold through hundreds of wholesale distributors and thousands of retail outlets. A market with that kind of diversity is often subject to intense competition which, in turn, breeds price volatility and the need for reliable risk management tools.

Like other NYMEX Division contracts, the New York Harbor Unleaded Gasoline futures contract provides for physical delivery in New York Harbor. The harbor is a major distribution center on the East Coast for domestically produced and imported supplies, and is connected to the major refining centers on the Gulf Coast, and to other important market centers, through a network of interstate petroleum pipelines.

Who Uses the NYMEX Division Unleaded Gasoline Contract?

The NYMEX Division Unleaded Gasoline contract is of benefit to most sectors of the petroleum industry including refiners, blenders, importers, distributors, and integrated marketers, availing them of the opportunity to protect their cash market positions from changes in market pricing.

Commercial users, such as fleet operators, can also use the unleaded futures contract to hedge against price risk in meeting their fuel procurement needs, and to help stabilize procurement costs.

Speculators in the futures markets fulfill several vital economic functions by facilitating the marketing of basic commodities and the trading in financial instruments. Speculators do not create risk; they assume it in the hope of making a profit. In a market without these risk takers, it would be difficult, if not impossible, for hedgers to agree on a price because the sellers (or short hedgers) want the highest price, while the buyers (or long hedgers) want the lowest possible price.

In addition to assuming risk, providing liquidity and capital, speculators help ensure the stability of the market. Speculators trade in the futures markets to profit from price fluctuations. The price of grain, for example, changes along with supply and demand. Plentiful supplies at harvest time usually means a lower price for grain. Higher prices may result from such things as adverse weather conditions during the growing season or an unexpected increase in export demand. Financial instruments fluctuate in price due to changes in interest rates and various economic and political factors.

When speculating in the futures markets, both profits and losses are possible - just as in owning the actual, physical commodity.

Speculators "buy contracts" (go long) when expecting prices to increase, hoping to later make an offsetting sale at a higher price, thus, at a profit. Speculators "sell contracts" (go short) when expecting prices to fall, hoping to later make an offsetting purchase at a lower price, again, at a profit. What is unique about futures is that a speculator can enter the market by either purchasing or selling a futures contract. The speculator's decision of whether he should buy or sell depends on his/hers market expectations.

The profit potential is proportional to the amount of risk that is assumed and the speculator's skill in forecasting price movement. Potential gains and losses are as great for the selling (going short) speculator as for the buying (going long) speculator. Whether long or short, speculators can offset their positions and never have to make, or take, delivery of the actual commodity.

The liquidity and efficiency of the NYMEX Division gasoline futures contract have made it by far the most frequently used and most effective risk management and price discovery tool in regional, national, and even international gasoline markets.

Unleaded Gasoline Options

NYMEX Division Unleaded Gasoline options provide a flexible means for hedgers (commercials) to achieve price protection while retaining the ability to participate in favorable price moves. The opportunity cost is limited to the premium paid for the option, plus the commissions and fees.

Options Defined

There are two types of options: calls and puts. A call gives the buyer the right, but not the obligation, to buy futures at a specific price (the strike or exercise price) for a specific period of time. A put gives the buyer the right, but not the obligation, to sell futures at a specific for a specific period of time.

Buying a call or a put is similar to purchasing an insurance policy: In return for a one-time up front premium, the buyer obtains protection against the occurrence of a risk. To protect against the risk of a price increase, a hedger would purchase a call, to protect against a price decrease, he would buy a put.

If the price move does not occur, that is, if cash market (spot) prices do not move in an adverse direction, the options buyer forfeits only his premium and is otherwise able to participate fully in any favorable price move.

An options seller (or writer) performs a function similar to that of an insurance company. The seller collects the premium and is obligated to perform, should the buyer exercise the option. If the option expires without being exercised, the options seller profits by the amount of the premium.

A hedger can set a "Cap" on Gasoline Prices by Buying Calls

Assume that in April a gasoline buyer for a taxi fleet becomes concerned about a possible increase in summertime prices. June gasoline futures are trading at $0.65. The buyer considers purchasing futures contracts, thereby locking in a purchase price of $0.65, exclusive of taxes, for his June supply. However, he does not want to be significantly above the market should spot (cash market) prices decline, and thus decides to buy a June call with a strike price of $0.65 for 4 cents.

On May 21, the gasoline buyer purchases spot fuel and liquidates his options position. The chart below illustrates the results if the price of gasoline has increased to $0.85 (Case A) or if it has declined to $0.50 (Case B).

In Case A, the gasoline buyer pays $0.84 to his supplier for fuel, but the financial offset provided by the $0.16 option profit gives him an effective gasoline cost of $0.69. This is $0.04 more than his effective cost when using futures to hedge, because he paid $0.04 for the option.

The reason the buyer chose to pay this $0.04 becomes apparent in Case B. The buyer pays his supplier $0.50. The $0.65 call - the right to buy futures at $0.65 - now has no market value because his futures are trading at $0.50. So there is a net loss of $0.04 - the options premium paid - on the options position, giving the taxi fleet an effective gasoline cost of $0.54. This is $0.11 less than if futures alone were used to obtain price protection.

A hedger can set a "Floor" Against a Gasoline Price Decline by Buying Puts

In April, a gasoline refiner is concerned that a cool rainy summer will drive prices down. With June futures trading at $0.65 per gallon, the refiner considers selling futures to lock in that price.

He realizes, however, that if the weather is fair and conducive to vacation traveling, prices could rise well above $0.65, and he would like to be able to earn the higher revenue. He decides , therefore, to use options instead of selling futures, buying a June put with a strike price of $0.65 for $0.04.

On May 21, the refiner sells his supply commitments for June and liquidates his options position. The chart illustrates the results if the price of gasoline has fallen to $0.50 (Case A) or if it has increased to $0.85 (Case B).

In Case A, the supplier receives only $.50 for his gasoline, but the financial offset provided by the $0.11 option profit gives him an effective selling price of $0.61. This is $0.04 less than his effective revenue when using futures to hedge, because he paid $0.04 for the option.

The reason the supplier chose to pay this $0.04 becomes apparent in Case B. The refiner now receives $0.85 from the spot market sale. The $0.65 put - the right to sell futures at $0.65 - has no market value because futures are trading at $0.85. So there is a net loss of $0.04 - the options premium paid - on the options position, giving the gasoline supplier an effective selling price of $0.81. This is $0.16 more than if futures were used to obtain price protection.

Unleaded Gas Contract Specifications

See Also: Unleaded Gas Futures and Options Special Report