On April 1, Moon Chemical agreed to sell petrochemicals to the U.S. government in the future. The delivery dates and prices have been determined. Because oil is a basic ingredient in the production process, Moon Chemical will need to have large quantities of oil on hand. The firm can get the oil in one of two ways:

1. Buy the oil as the firm needs it. This is an unhedged position because, as of April 1, the firm does not know the prices it will later have to pay for the oil. Oil is quite a volatile commodity, so Moon Chemical is bearing a good bit of risk. The key to this risk bearing is that the sales price to the U.S. government already has been fixed. Thus, Moon Chemical cannot pass on increased costs to the consumer.

2. Buy futures contracts.6 The firm can buy futures contracts with expiration months corresponding to the dates the firm needs inventory. The futures contracts lock in the purchase price to Moon Chemical. Because there is a crude oil futures contract for every month, selecting the correct futures contract is not difficult. Many other commodities have only five contracts per year, frequently necessitating buying contracts one month away from the month of production.

As mentioned earlier, Moon Chemical is interested in hedging the risk of fluctuating oil prices because it cannot pass any cost increases on to the consumer. Suppose, alternatively, that Moon Chemical was not selling petrochemicals on a fixed contract to the U.S. government.

Instead, imagine that the petrochemicals were to be sold to private industry at currently prevailing prices. The price of petrochemicals should move directly with oil prices because oil is a major component of petrochemicals. Because cost increases are likely to be passed on to the consumer, Moon Chemical would probably not want to hedge in this case. Instead, the firm is likely to choose Strategy 1, buying the oil as it is needed. If oil prices increase between April 1 and, say, September 1, Moon Chemical, of course, will find that its inputs have become quite costly.

However, in a competitive market, its revenues are likely to rise, as well.

Strategy 2 is called a long hedge because one purchases a futures contract to reduce risk.

In other words, one takes a long position in the futures market. In general, a firm institutes a long hedge when it is committed to a fixed sales price. One class of situations involves actual written contracts with customers, such as the one Moon Chemical had with the U.S. government.

Alternatively, a firm may find that it cannot easily pass on costs to consumers or does not want to pass on these costs. For example, a group of students opened a small meat market called What’s Your Beef near the University of Pennsylvania in the late 1970s.7 This was a time of volatile consumer prices, especially food prices. Knowing that their fellow students were particularly budget-conscious, the owners vowed to keep food prices constant regardless of price movements in either direction. They accomplished this by purchasing futures contracts in various agricultural commodities.