Using commodity collars to manage market volatility

Introduction

Commodities markets experienced extreme disruptions due to the widespread financial impacts of the global coronavirus pandemic. Energy prices completely collapsed while other commodities, such as lumber, initially fell and then rallied strongly due to plant closures. The wheat markets rallied, fell, and then rallied again in a whipsaw pattern that made risk management highly challenging. Companies hedging with swaps saw wild swings in hedge portfolio valuations, while companies without hedging programs were exposed to prices doubling in just a matter of weeks. The dramatic increase in volatility made options-based hedging programs prohibitively expensive. If your organization is exposed to these difficult market conditions, you may wish to consider employing commodity collars, a hedging structure that pairs a price ceiling with a price floor, bounding the range of future prices and reducing the amplitude of the price peaks and troughs.

Commodity Collars

Options overview

A commodity option is a financial instrument that enables a buyer to pay a premium in exchange for the right, but not the obligation, to transact at a predetermined price, at a future point of time. A call option is the right to purchase while a put option is the right to sell.

• Call options provide protection against rising markets while allowing the option holder the opportunity to benefit from falling prices.
• Put options protect the option holder against falling prices while retaining the benefit from upside market movements.

Calls are frequently used by market participants who are “short” the underlying commodity; for example, a distribution company that will be buying market-priced fuel at a point in the future. Puts are used by producers or manufacturers that are long the physical product and concerned about losing value in inventory that will be sold at some point in the future. The upfront payment (the option premium) made to the option seller is driven by several key variables: the predetermined future transaction price (the strike price) relative to the current forward market price, the amount of uncertainty (volatility) in forward market prices, and the time remaining until the option expires. Longer dated options in high-volatility markets represent a greater probability that the option will settle as a liability to the option seller and are generally more expensive.

Creating a collar

Many corporate clients with exposure to forward prices can absorb some amount of price variance. Their hedging program’s objective is to reduce, not eliminate, that variance. Depending on market conditions, collars can serve as an excellent tool to bound the range of future prices. As a consumer client with a future physical floating-price supply requirement, you would create a collar by first purchasing a call to protect against an upward movement in prices. To reduce or eliminate the cash requirement to pay for your purchased call, you would sell a put option, usually with an offsetting premium. This short option position creates the obligation for you to buy at the strike price should market prices fall, limiting downside opportunity in exchange for reducing upside risk. Pairing these two options positions creates an upper and lower boundary for forward prices requiring little or no cash outlays at the time of execution.

In the above example, a diesel fuel hedge is created when a sold $1.30 put is paired with a purchased $1.60 call and the prevailing forward market price is $1.44/gallon. The option would pay out if the market price at the time of settlement is above $1.60, offsetting higher physical fuel prices, and would become a liability below $1.30, with the liability offset by lower physical fuel prices. Between $1.30 and $1.60/gallon, there would be no payments made or received. You can structure the collar width as wide or narrow to align with your organization’s risk tolerance.

Collars capture the benefit of offsetting volatility and time-pricing factors

Volatility Offset

Market volatility is a key driver in option pricing. Higher volatility increases the possibility that an out of the money option could settle “in the money” to the buyer, and the potential size of the resulting settlement payment. A market swinging up and down by 5% or 10% per day is far riskier than a market moving up and down by just a few tenths of a percentage point. When a purchased call is paired with a sold put, the volatility components offset somewhat. There may be some small differences between call and put volatility captured in the premium prices, but the collar buyer is not paying for the full cost of purchasing an option.

Time Value Offset

In conjunction with volatility, option prices are also driven by the time remaining until the option expires. The longer dated the option, the higher the price, since longer dated options allow more time for the option to become an asset to the purchaser. In much the same way that the put/call volatility components can be offsetting, the same holds true for time value, making longer dated collars a cost-effective alternative to outright puts or calls.

Collar Pricing Parameters

Collar width

When evaluating a collar-based hedging strategy, a key consideration is the “moneyness” of the options. When comparing the strike price of the option to the current market price, we refer to options as “in the money” if the strike is below the market for a call or above the market for a put. An at-the-money option is one where the market price and strike price are the same, and an out-of-the-money (OTM) option occurs when the strike is unfavorable relative to the market price. In most cases, collar transactions are done with both legs (the put and the call) being out of the money, thereby creating offsetting premium payments to make the transaction costless. The key question becomes how far out of the money should the strikes be? There is no set answer to this question; it entirely depends on risk tolerance. A consumer with a forecasted natural gas expense of $25 million and the ability to absorb no more than a $2.5 million variance on that amount would use a much tighter collar than a consumer who could absorb a $7.5 million variance.

Hedge ratio

When calculating the hedge ratio, you must consider the “width” of the collar to ensure all stakeholders are accurately apprised of the amount of risk reduction achieved by the collar relative to current market and the call strike. If the collar is wide, a higher hedge ratio may be appropriate such that the combination of unhedged exposure plus the slippage occurring before the call goes into the money, remains below the overall risk tolerance. For instance, a company exposed to 1 million barrels/month of Brent hedged to 50% with a collar that is 10% OTM at inception would incur an unfavorable variance of $7.5 million when the forward price of Brent increases from $50 to $60. This is $2.5 million higher than one would expect with a 50% hedge ratio on 1-million-barrel exposure.

Settlement mechanism

When placing a hedge using collars, it is important to be certain that the settlement mechanism for the collar matches the pricing structure of the underlying physical exposure. In most cases, physical supply is priced using either a daily spot price or the final settlement price for a specific contract month. For example, natural gas may be priced based on the NYMEX Final Settlement Price plus an adder for basis. In this case, the hedge would use the NYMEX Final Settlement price and the hedge would be settled on the day of contract expiration. Conversely, a fleet owner who is purchasing fuel at the pump would want to settle against the daily published price for NYMEX Ultra Low Sulfur Diesel Fuel as the daily pump price is highly correlated to the futures daily settle price.

Collars or swaps

Many companies use swaps-based hedging programs because they are efficient and effective hedges, easily executed in the market with minimal bank margin, and do not require any upfront cash payment. In many cases, market data is readily available via Bloomberg to discern mid-market price levels and validate bank margins embedded in the swap rate. In exchange for the transaction efficiency, one downside to swaps is they are almost immediately an asset or liability and, in virtually all cases, will require the swap buyer to make or receive a payment when the swap settles. In exchange for providing an immediate cap on rising prices, swaps forego any opportunity to capture downside benefit.

Unlike swaps, collars allow some room for market movement in either direction before requiring a settlement payment. If a hedger can absorb up to a 5% swing in prices, collars can provide protection beyond that 5% swing while allowing some benefit in a falling market. The challenge with collars is ensuring efficient pricing. Options are far more difficult to price than swaps, and opacity in the volatility rates used to price OTM options can exacerbate the pricing challenge. Before embarking on a collar-based hedging strategy, therefore, your organization should access an accurate options pricing model.

You should also consider the intersection of the forward volatility versus the forward price. If prices are near historic highs and volatility is low, options will be relatively inexpensive, and an option strategy may be preferable to a swap or collar strategy. Conversely, if prices are low with limited downside opportunity, swaps or tight collars may be an economical alternative.

Collars are not costless

Collars are frequently referred to as zero cost because banks will trade them with no upfront cash required. The cashless transactions are perfect for companies that want to mitigate risk without paying upfront premiums for options but also don’t want the potential liability and loss of downside benefit associated with a swap. Banks don’t trade for free and collars are no exception to that rule. The banks embed their margin in the strike price of one of the legs of the collar, usually the put side for a consumer collar and the call side of a producer collar. The bank will sell one option at x% out of the money and buy the offsetting option at something less than x%, such that the difference in the moneyness of the strikes yields margin on the trade for the bank. Referring to our diesel fuel example, if the fleet owner hedged his 2021 diesel fuel exposure with the market currently at $1.44, the $1.60 purchased call would be paired with a $1.30 sold put. The call is 16 cents OTM, while the put is only 14 cents OTM. This is a relatively minor difference to the end user but provides the desired protection at $1.60 with no cash outlay and 14 cents of downside opportunity.

Credit, documentation, and accounting considerations

ISDA requirements

Collar transactions are generally classified as derivatives and, in most cases, banks will require that an ISDA be completed before transacting. This requires your organization to complete the Know Your Customer (KYC) process and negotiate an ISDA Master Agreement, ISDA Schedule, and a Credit Support Annex (CSA). This process can take several weeks to complete, and even if your organization is “well banked,” you should confirm that your selected banks for commodities hedging are well versed in options trading and capable of executing at efficient pricing levels. The nuances of commodity trading may require that new banks be added to the bank group to ensure efficient execution.

Collars are credit trades

When hedging with a collar, the purchased option leg is offset with a sold option leg and this sold option could potentially become a liability to the seller. For this reason, banks will require counterparties trading collars to have established credit or be subject to collateralization immediately upon the option becoming a liability.

Hedge Accounting

Accounting considerations for risk mitigation transactions are a key component when selecting a hedging structure. In general, sold options cannot qualify for hedge accounting. However, when the two options are executed together as a paired transaction and there is no net premium received, the collar structure may be eligible for hedge accounting treatment provided the existence of a strong correlation between the underlying physical exposure and the hedging index can be validated. This can be problematic as options markets only exist on the most liquid indices and it is not uncommon for the physical exposure index to not have a viable options market. Many fuels and base metals price on spot indices with limited or no forward markets, as is the case with aluminum. Aluminum produced and consumed in the U.S. is frequently priced using the Platt’s Midwest Transaction Price (MWTP) which is an index representing the price for physical aluminum bought, sold, and delivered in the U.S. Midwest. While there is an active forward market for swaps on MWTP, banks do not offer options on the index. Because of this, companies looking to hedge MWTP risk with option products often execute LME aluminum contracts, which has a liquid options market and tends to be reasonably well correlated with MWTP. Assuming the correlations between the two indices are sufficiently strong enough to meet the hedge accounting effectiveness test requirements, the exposure could be hedged using an LME Aluminum collar and floating the basis differential risk between LME and MWTP. The hedge accounting requirements when there is an index mismatch are complex and companies contemplating this type of hedge should thoroughly review ASC 815 or consult an accounting expert prior to executing the hedge to confirm that the hedge will qualify for the desired accounting treatment.

Next steps

If your organization seeks to minimize its exposure to today’s extreme commodity market conditions, commodity collars can limit future price fluctuation. Your Chatham Financial advisor can support you in selecting and structuring the appropriate hedging instrument, attaining efficient pricing, and addressing credit, documentation, and accounting considerations.

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