Given the recent basis "blowout" between NYMEX WTI and ICE Brent crude oil we thought it would be a good time to revisit basis risk and the implications of such as it relates to hedging.

As the chart below indicates, there has been a significant disconnect between WTI and Brent futures in recent weeks.  The black line shows the NYMEX WTI front month futures, the red line shows the ICE Brent front month futures and the green line shows the basis (difference) between the two.  While we could spend hours debating the reasons for the disconnect, suffice it to say that the demand for Brent futures is currently higher than the demand for WTI futures.

So what does this have to do with hedging?  In simple terms, imagine you're an airline that hedges much of your jet fuel exposure with crude oil swaps and/or options, as many airlines do, as crude oil derivatives are more liquid than jet fuel derivatives.  Further suppose that for whatever reason you chose to hedge your fuel exposure with swaps or options that settle against NYMEX WTI futures. 

Lastly, let's assume that your airline flies a decent number of routes to/from Europe (e.g. all of the majors), where your fuel costs relect the price of the ICE Brent market rather than the NYMEX WTI market.  Historically, as the chart indicates, your exposure to the Brent/WTI basis was relatively minor (another point that could be debated until the end of time), let's call it an average of $2 per barrel, but clearly that is no longer the case. What used to be $2/BBL is now $13/BBL. 

So to come full circle, back to hedging, let's assume that the majority of your 2011 hedges are swaps or call options on NYMEX WTI at $85/BBL.  If you're annual fuel consumption is 100MM gallons and 1/3 of your fuel (33MM gallons) is purchased in Europe, you're purchasing approximately 2.7MM gallons per month in Europe.  You've hedged this exposure with NYMEX WTI at $85/BBL yet your actual cost on your European fuel exposure is now ~$100/BBL while your hedge is only "paying out" at ~$87/BBL.  In short, while you thought you were hedged, your hedge is only capturing a portion of your exposure, leaving you between a rock and a hard place to the tune of $35,750,000 based on current market prices. 

To summarize, this is what can happen when you don't properly address basis risk.  And basis risk isn't limited to jet fuel or crude oil end-users.  Numerous natural gas producers have been punished in recent years for ignoring their basis risk as they chose to only hedge their NYMEX (Henry Hub) risk.  Likewise for many natural gas consumers.  And the list goes on.

On another note, we are in the process of rolling out the schedule our 2011 educational, hedging seminars.  If you are interested in attending a seminar covering specific aspect of energy hedging (e.g. crude oil and natural gas hedging for E&P companies, diesel fuel hedging for end-users, etc.) and/or if you would like to suggest a location, please let us know and we will do our best to accommodate you.