In San Francisco, depending on where you go right now, tomatoes might be $20 a case or they might be $40 a case. Why is any place selling them for $40 a case? I honestly couldn’t tell you other than there was probably a problem somewhere with the tomato crop. But if you’re able to get them for $20 a case right now, it’s because that store was able to get them for a good price, and that means somewhere upstream in the supply chain, a futures contract was exchanged which made that possible by locking in the purchase price in advance for this batch of tomatoes.
This is often the case with avocados which might sell for $0.50 a piece in one place or up to $3 a piece in another. Anything can affect the price, up to and including cartels in Mexico demanding protection money from Avocado farmers recently, but pests, weather, soil problems, or whatever might limit the supply and lead to price increases.
Walmart, being Walmart which isn’t unlike being Costco or any other major supermarket of sorts where people buy food, would want to limit their exposure to shocks in the market regardless of what’s causing the shocks. So they would need to employ futures traders in order to accomplish this. Even if they lose money on some contracts, they’re probably making money on enough of them to keep their prices low when you go there to buy tomatoes, avocados, lettuce, spinach, meat, poultry, or whatever. Nobody is happy when the price of tomatoes suddenly doubles almost overnight, and especially not the customer.
Technically that's the original use case of futures contracts - you pay now, and lock the price. You might lose some (due to prices falling down, supply not fulfilling the contract) or win some (due to issues in supply, prices going up, etc.).
On the other hand, the supplier gets money now, not some time in the future (like after harvest) and this provides a different kind of cash flow that doesn't invoke debt (usually).
And then there's trading on the contracts all around, trying to get best prices :)
That's amazing! In this sense, every company (well, at least every big company which deals with commerce and commodities) must be a financial company. Which explains why this is a big market.
I understand hedging tomatoes if Walmart is selling tomatoes. However, the OP says "oil futures". I think Walmart doesn't sell crude oil, heating oil, soybean oil. Even for transportation, you'd hedge gas, diesel etc. I wonder why oil futures.
It's the same principle just a couple layers removed. A spike in oil prices means a downstream spike in anything that needs to be transported via truck, which is approximately 99.8% of what Walmart sells.
To be honest I didn’t see the word “oil” initially, but other comments already addressed this: Walmart does have to deal with large quantities of oil and related commodities. In addition to their grocery business, they also run a large logistics operation, and the price of the goods and groceries in their stores at the end of the day doesn’t exclude the cost of their transportation to those stores.
Walmart trades oil futures for the same reason Southwest Airlines does.
During the mid-2000s, Southwest got so good at hedging and futures trading--plus was one of the only airlines that hadn't gone bankrupt so had the cash and credit and good reputation to trade on--that it was routinely called "a commodity desk that happens to fly airplanes."
I imagine that, just like airlines use futures to hedge the price risk of jet fuel, they do the same for their vast logistics operation. They can lock in prices so they aren’t suddenly facing a massive bill if gas goes way up.
Not just fuel for their logistics, but also selling gasoline in their Wal-Mart brand gas stations near their stores, Neighborhood markets, and Sam's Club. They ditched Murphy USA a few years back for much of this fuel and began sourcing it themselves. It's a way to ensure those prices are the lowest they can reasonably offer and still turn a profit.
Hedging is extremely odd in that while it is thought of as a way to lock in 'certainty' on the price of something, it really is just another way of gambling on a price.
In the case of airlines, they are effectively 'short' oil, in that they profit if the price of oil falls, and lose if the price rises. So the usual story is that it makes sense to hedge their oil costs. They can do this in three main ways:
1) Buy oil forward. They get to lock in the price of oil at a future time. If oil prices rise, they win. But if oil prices fall, they lose out, since competitors can now buy oil more cheaply.
2) Buy a call option on oil. They get the right to buy oil at a fixed price at a future time. If oil prices rise, they can exercise the option, and win. If oil prices fall, they can just take the cheaper price => another win. But the option itself has a cost, so if oil prices don't change much, they lose out since they had to eat the cost of buying the option.
3) Sell a put option on oil. This is the airline being paid by someone for the option to sell them oil at a fixed price at a future time. In this case, the airline wins if oil prices don't move too much in any direction (since they get paid for the put option). If oil falls in price, they will have to buy it at the higher price => they lose. If the oil price rises, they also lose since the costs have risen.
Yet, in all cases, after hedging, the airline will still either win or lose depending upon the change in oil price. No certainty has been gained.
The choice whether to hedge or not is really down to game theory. What matters is not just whether/how your airline hedges, but what your competitors do.
> Yet, in all cases, after hedging, the airline will still either win or lose depending upon the change in oil price. No certainty has been gained.
That’s not really true. You’re locking in the price that you’re going to pay - that’s the certainty. You might however not be getting the best price at that point in time. From a financial forecasting perspective it probably worthwhile trade off though as you’re fixing one of your costs for that time period and that’s useful even when sub optimal.
There's still no certainty. For an airline, your prices have to be competitive. If you've locked in an oil price, and it turns out to be a high one, then your fares will be more expensive than your competitors (assuming that they didn't hedge in the same way). So the only certainty there is failure.
In all situations, hedging and non hedging, the oil price will determine whether you win or lose. There is no magical combination of derivatives that will ensure success. In fact, for every financial product you buy, you're paying a cost due to the margin that the bank/market charged you.
Hedging might make sense for some accounting/tax situations, but that's another issue entirely.
You are free to lose money by keeping the prices competitive, or lose money by raising your prices and losing business. Either way, it's the same result.
Airlines sell tickets in advance, so hedging will allow them to match their near-future fuel prices to the ticket prices they're selling now. They consume fuel but don't produce it, so I don't think they can fully balance things out over time internally.
edit: I see this was mentioned already in the thread.
> There's still no certainty. For an airline, your prices have to be competitive. If you've locked in an oil price, and it turns out to be a high one, then your fares will be more expensive than your competitors (assuming that they didn't hedge in the same way). So the only certainty there is failure.
A huge chunk of airline tickets are sold in advance. The oil futures can literally lock in the prices for only sold airfare if you're that paranoid.
Also (probably more important), the cost of oil on a given ticket is quite low and it would take a drastic change in oil prices for it to be obvious to customers comparison shopping.
> Hedging is extremely odd in that while it is thought of as a way to lock in 'certainty' on the price of something, it really is just another way of gambling on a price.
Actually, yours is a rather odd take on the term 'certainity' itself! To clarify, I'll lay out the layman take & the quant take.
The layman explanation is - life is a gamble but I wear seatbelt. Because that's the certainity I won't die by being thrown off the seat. Yes, that might mean I might die in other ways. Like maybe the car dives into a lake & I couldn't get out because the seatbelt is stuck so I drown to death. But the car in lake probability is smaller than car collision probability. So I have purchased certainity in my mortal affairs by wearing the seatbelt. Atleast if my car collides with another car, I don't get thrown off for certain.
The quant problem is the same. My quant professor at UChicago always insisted "only losers buy stocks". He repeated that in so many ways that lesson stuck to all of us. Like, stocks are for losers. Quants don't buy stock, losers do. Now why did he take such a radical stand ? Stocks are a random variable so there is no certainity. That's the very definition of positive rv y(t), it can do anything on the positive y axis, because it is random. But you are not completely helpless. You can buy certainity on both the x & the y axis! And on functions of those if you are clever. So if you pay put premium on a 1 month expiry with say strike at 1 sigma, you are saying I am only willing to lose 1 sigma from my present mu within next month. If my stock falls below mu-1sigma, then some other loser better pay up. Who is that other loser ? The guy who sold me the put option. Because he holds the opposite belief, which is why he sold me the put. So I am certain I won't lose below 1 sigma. I have literally purchased my certainity by paying that put premium. The loser why sold me the put is also certain it won't go below 1 sigma, which is why he gets to collect my premium. Now, what will really happen ? Well, who the fuck knows. The stock is a random variable, so anything can happen. But neither of us have bought the stock. I have bought 1 certainity, the seller has sold another certainity. So its a win-win on the certainity axis. Because my max loss is capped at mu minus one sigma, I am certain of that. So even though underlying is random I am certain!
> No certainty has been gained. is really down to game theory.
This is simply not true. A lot of certainity has been gained, which is literally why money has been exchanged. Price of certainity is by definition the premium.
Show me where the certainty is, then! In all cases (being unhedged, hedging against rising, falling, stationary or volatile prices), the airline can still be adversely affected by the future oil price. Either directly, or through becoming unable to compete profitably with rivals who did not hedge.
You can make an indirect bet on oil futures by trading airline stocks. Southwest Airlines (LUV) if it's going up, American Airlines (AAL) if it's going down.
I think the difference is that by the time an airline is buying fuel, they have already sold the tickets at a certain price. So hedging makes sense. That’s not the case with Walmart for produce - if tomatoes are more expensive to buy they can just sell them for more. The only things for which it makes sense are those that aren’t sold back, eg the fuel for their fleet of trucks etc
Yes, if gas prices doubled, Walmart could increase the price of their products, but consumers would likely buy a lot less, and Walmart sales would suffer.
Walmart’s focus is on “low, everyday prices”, and future can help maintain those.
There is absolutely no more reason to keep prices low if you've made a profit independently on futures than if you haven't.
Your marginal cost goes up in both cases. If you're optimising profits, you should make the same decision in both cases regardless of if you bought futures.
Accounting wise, the fact you made a profit on futures is unrelated to your current costs buying in the physical market.
Most likely the futures in question aren't being physically settled.
Regardless, the economic cost is what determines incentives to raise price for a rational actor. For my claim above to be wrong, Walmart and co would have to be irrational.
I’m totally ignorant about this part of the world, but I imagine they can only reliably sell them for more if someone else isn’t selling them for less. And if the someone else is hedging, they might.
Locking the costs at a fixed amount for a fixed amount of time. This certainty allows retailers to plan promotions, discounts levels, special offers without impacting profitability. It also simplifies accounting and budgeting. Making a profit from the hedge is not really a priority (it is difficult enough for professional trading firms with full research departments at their disposal). Also, retailers (and other producers, like coffee roasters) MUST buy their raw materials quite regularly, so the profit potential of hedging tends to average out.
Generally speaking most people have no idea how integrated companies are into the "global economy" in a general sense. Just pick any random international company and they have multiple jurisdictions, currencies, currency risk, commodity risk, investor relation, internal portfolios and cash management, funds. All of this for one company, now imagine all companies and all the people, data, and connectivity required to manage it.
Actually, many large companies employ traders in their Treasury Group, under the CFO function. As other comments state, this is to hedge risk. Specifically, most big multinational companies have to hedge FX risk constantly. Depending on your industry, you may have specific risks (e.g. I once had a client who was a clothing manufacturer and they had a cotton futures trader on site.)
Off topic on topic but futures trading is pretty much the most useful actual trading out there. One can argue people are gambling (otherwise known as "investing") almost 99% of the time with trading.. but futures can actually be used for mutual gain.
You are a corn grower and want to lock in a price 6 months from now. You are someone who buys a lot of corn and want to lock in the price 6 months from now. Futures allow you in essence to meet up in a highly liquid exchange where you can lock in those prices for the buyer/seller. Win-win for both, because they get the price security they desired.
Of course the vast majority of futures is speculative, which provides liquidity for the hedgers..
The core reason futures exist is to allow you to maintain more stable pricing of the products you sell, in the face of price instability in the products you buy. Let’s say you’re Pizza Hut and you want to run a Super Bowl ad advertising $5 pizzas for a month. But then a tomato sauce recipe goes viral in China and the price of tomatoes goes up 2x. Now your promotion might be costing you a lot more than you had planned.
With futures you can buy the tomatoes today, to be delivered later, the farmer can get his money now and you van lock in your price now, insulated against increases in prices (with the farmer insulated against decreases).
