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fuel, causing financial disruptions.How can the airline guarantee stable jet fuel prices for at least some time into the future?

Enter futures. The airline can purchase gasoline futures contracts to cover some or all of its anticipated jet fuel needs any number of months or years from now. The contracts then allow the airline to pay a certain price for a certain amount and quality of fuel now and take delivery of the fuel at the maturity time of the contract regardless of future price fluctuations. The advantage for the airline is that it can get a handle on its jet fuel costs for some time into the future. So what is the catch? There is certainly a catch here where the airline could potentially be at a disadvantage. For example, if the price of gasoline suddenly drops, the airline cannot benefit from the lower prices since it already locked in at the contract price. Also if the airline’s jet fuel demand decreases it must still take delivery of the full amount specified by the contract. That is the risk the airline must be willing to take to guarantee price stability for its jet fuel.

One way to reduce such risks is for the airline to buy fewer gasoline futures contracts. In that case the airline obtains a portion of its fuel requirements through contract delivery and the rest on the open (spot) market, thereby gaining partial price protection while allowing it to partially benefit from price drops, if any. Another way is to settle some of its contracts prior to maturity.We’ll explain this soon.

That was of course just an example illustrating the theoretical benefits of futures. In reality less than 4% of futures contracts result in physical delivery of the underlying commodities. In most of the cases the contracts are settled without the actual underlying commodity entering the picture. The supply and demand for the underlying commodities have a direct impact on the prices of their respective futures, but traders rarely, if ever, get to see the actual commodities. …