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So youd like to buy a few more rigs and expand the business. But everyday the price of your asset jumps around and the bank wants to see stable cashflows before theyll make the loan. Its time to hedge. But how to do it? Lets explore some representative hedging choices available to the oil producer. Well start with the most basic ways to eliminate the price exposure and then add bells and whistles to generate ever more complex, custom risk profiles.
No Math
It could happen.
Before we start, lets address the elephant in the elevator. This stuff can be daunting and offputting. There are countless permutations. But all this variation flows from just a few building blocks. Its like a Mexican restaurant. No matter what you order, rice, beans and tortillas will probably feature prominently.
Comfort food
If youre long, you can take an offsetting short position. You can get flat. Here are three means to that end.
forward sale is convenient in that the date, product and location can be tailored to match the long position.
Sell futures
The third option is to sell crude oil futures. No credit facility is required, however there will be a daily margining process. Futures are standardized. So they may not precisely offset your long position in terms of date, product and location. Any mismatch creates a basis risk.
Lets say its now the first of June and you want to hedge production for July. For simplicity, spot and forward prices are all $100. Crude prices are expected to have an annualized volatility of 30% going forward. The interest rate is 0. Under this scenario, each of the three instruments above would theoretically trade at $100.
The problem with getting flat is that there is no opportunity to benefit from rising prices. What if instead of eliminating the exposure, the goal is to simply reduce the risk of lower prices?
Spicing it up
You could buy a $90 put for the end of July. A put gives you the right to sell at the strike price, $90, on or before a certain date. So if prices end below $90, you are protected. If prices end above $90, the option expires worthless and the oil is sold at the market price. Such a put might cost $1.24. We now introduce what will be a recurring theme. You like the price insurance, but you dont like the price of the insurance. What can be done? Well, production will be available over the month, not just at the month end. So instead of a one time exercise at the end, you might buy a strip of daily $90 puts for July. Because almost all expirations will occur before July 31st, the option will be cheaper. Perhaps $.84. But are do you really need to sell above $90 each day? Arent you really trying to protect your average price? Lets say prices oscillated between $89 and $91. The strip of daily options would pay off $1 on half the days. Thats more price insurance than you may need. An Asian put, so named because Bankers Trust Tokyo office first traded them in 1987, would protect you against a lower average price than $90 at a theoretical cost of $.70. Asian options are also called average price options (APOs).
Eric Lubin is a crude derivatives broker at Starsupply, a division of GFI Brokers. Starsupply is a leading US broker of oil and related derivative and option contracts. As would be expected, Eric confirms that APOs are the most popular instruments. In fact, we crossed a nominal $300 million dollars worth of a cal 13 fence earlier today. All were APOs.
OK. $.70 is certainly better than $1.24. But I still hate having to pay it. Other than reaching into my pocket, how can I fund this price insurance?
The same volatility that might cause you harm by moving prices lower might benefit you by moving them higher. The fact that you stand to benefit from higher prices is an asset that can be sold. So were comparing apples to apples, well focus on the average price put option that costs $.70. That can be funded by selling the right to an average price higher than $111.71. You have bought the $90 put and sold the $111.71 call. The structure has many names: a fence, a zero cost collar, a risk reversal or a range forward among them.
Knowing that people dont like out of pocket expenses, many structures will be pitched on a zero cost basis. But zero cost structures can cost plenty.
Interesting. So I can sell my right to gain from price appreciation. What if I was willing to do a lot of this? Is there a way that I could actually improve on the current forward level?
Why, yes, there is. Lets call it a double up forward. Its just like a normal forward except that you may be asked to sell twice as much oil. You can sell a normal forward at $100. But you can sell a double up forward at $102.77. So if Julys average price ends below $102.77, you will sell at $102.77. If the price ends above $102.77, you will sell twice as much at $102.77. You have bought the $102.77 put and sold two $102.77 calls.
But I only have a certain amount of oil to sell each month. What if I agree to sell the second tranche a month later?
Even better. You can sell a do it again forward at $103.71. The price improvement is because the second call being sold expires a month later, applying to the average price in August. So it has greater time value. You have bought the $103.71 July put, sold a $103.71 July call and sold a $103.71 August call. Both previous structures involved taking on additional risk for an improved forward level today. The users are having their cake now. But there are also ways to eat your vegetables now and have your cake later. You could do the forward below the current market in exchange for a 30% participation in rising prices. Lets call it a participating forward. With a normal forward trading at $100, the participating forward trades at $98.59. If the average price for July is below $98.59, you will sell at $98.59. If the average price is above $98.59, you will sell 70% at $98.59 and 30% at the higher market price. You have bought a $98.59 put and sold .7 of a $98.59 call.
The bet
A digital option is familiar to anyone who has ever placed a bet with a bookie. I bet $1 that oil is above $100 on 31 Jul. This is a digital call with a strike of $100, expiration of July 31 st , pay off of $2 and a premium of $1. Digital options will have a value of 0 or 1 at expiration, ergo the name.
Digital options can be used in any number of ways. The following Let the rich pay structure demonstrates the concept and seems in keeping with the current zeitgeist. Here the poor, downtrodden
producer is given a $90 July put and only has to pay for it if oil finishes above $110. At that point, the rich, greedy producer is charged $3.50. The structure consists of a long $90 put and a short $110 digital option with a $3.50 payout. Digital options pay off based on the oil price at expiration. There is some possibility that prices will move above $110 but then settle below that level. So an option that pays off if $110 ever trades is more valuable and might make more sense for the producer who plans to rehedge at $110. This structure consists of a long $90 July put with a knock-out at $110 and a short one-touch option at $110 with a payout of $1.70. The knock-out put, which is worth virtually the same as the vanilla put, is funded by far fewer short options because the chance of breaching the $110 barrier is about twice as likely as ending up above it. Well stop there, though weve only scratched the surface. As these structures become better understood and commoditized, margins collapse. So the sell side must continuously innovate to find new ways to hide margin. The result of this financial arms race is spiraling complexity. But under the hood, we see the same building blocks vanilla and exotic options. Maybe you ordered a beef taco, burrito or enchilada. But back in the kitchen, it looks an awful lot like beef, rice, beans, and a tortilla.
Whats your current or prospective structure worth? Send a tweet to Larry @AnerisXTRM for a free independent assessment.
Larry Hickey is a Managing Director with Aneris XTRM and frequent contributor to these pages. He has spent the past 14 years managing implementations of industry leading ETRM solutions. In the 1990s, Larry originated and ran Irelands first FX option business for AIB.