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Conservative vs.

Speculative
3-Way Collars for Producers
Energy Derivatives Risk Management Series
As price volatility returns to energy and commodity markets worldwide, producers are starting to
ramp-up their hedging programmes. Some of the most widely used option combination structures
involve 2-way, 3-way and 4-way collars. In this piece, we discuss different types of 3-way collars, one
of the most widely used and misunderstood hedge instruments.
By Carlos Blanco
June 2013 83
A 3-WAY COLLAR is an extension of a standard collar,
but has a third option that effectively transforms a
relatively simple hedge structure into a considerably
riskier or more conservative one.
A standard collar is an option strategy that consists
of buying an option and financing its purchase with
the sale of another option. For example, producers
can buy put options for protection and finance their
purchase by giving away the price upside selling
call options. Many collars are structured so they are
costless at inception, because the premiums from the
options sold and bought are equal and therefore no
upfront payment is required.
There are two main alternatives for hedgers to
enter into 3-way collar structure. The first one is to
purchase and sell the individual options, and the
second one involves transacting it as an OTC structure
with a counterparty. Investment banks like to offer
3-way collars to producers and consumers, as it is
relatively easy to hide embedded fees inside the option
combination.
Speculative vs. Conservative 3-Way Collars
One of the key points to understand when analysing
3-way collars is the risk implications of adding the
third option to the structure to complement the simple
collar. In fact, the third option can turn the 3-way into
a highly speculative deal or a more conservative hedge
than the two-way collar.
If the third option is a purchased call deeper out
of the money (OTM) to cover the call option sold,
the option structure becomes considerably more
conservative. However, if the third option is a sold deep
OTM put, then the structure becomes substantially
more speculative.
Perhaps surprisingly, most firms that use 3-way collars
tend to choose the speculative type, even though we will
show it is not a good fit for most hedging programmes.
The reason why firms choose the speculative 3-way
is that there is an upfront premium received by the
hedger, but as we will see in an example, the structure
offers very limited protection against adverse moves
and also exposes the firm to potential large losses.
3-Way Collar Used By Natural Gas Producer
Let assume that on May 1
st
2013, a producer is looking
into hedging August 2013 expected revenues. The
NYMEX Henry Hub August 2013 Futures is currently
trading at 4.42.
The producer is interested in hedging with options.
The premiums of different calls and puts on the August
2013 contract are shown below.
An investment bank approaches the producer with
two alternative 3-way collar structures. We will assume
that the overall premium for the structure reflects
actual market prices, but in most cases, the banks are
able to charge embedded fees when they set up the
structure that could be minimized by hedgers if they
build their own.
Speculative vs Conservative 3-Way Collar
Overview of Simple Collar in the Structure
The first two options of the structure are the costless
collar not be confused with riskless collars, as many
hedgers have painfully learnt over time.
We can see that the premiums (Table 1) from the
$4.30 put and the $4.55 call are exactly the same, so
we could build a costless collar with those two options
and no premium exchange would be required. If the
producer did not add a third option into the structure,
Table 1: Option Premiums For
NYMEX Henry Hub August 2013 ($/MMBTU)
Strike Premium Strike Premium
4.20 Put 0.17 4.45 Call 0.26
4.30 Put 0.21 4.55 Call 0.21
4.40 Put 0.26 4.65 Call 0.17
4.90 Call 0.11
Table 2: Option Premiums For
NYMEX Henry Hub, August 2013
Aggressive Conservative
Buy $4.30 Put Buy $4.30 Put
Sell $4.55 Call Sell $4.55 Call
Sell $4.20 Put Buy $4.90 Call
June 2013
3-WAY COLLARS
we would be effectively setting a revenue floor of $4.30
and a revenue ceiling of $4.55 for the expected August
2013 production volume. Figure 1 above shows the
revenues for the producer before and after hedging for
a range of possible future price levels.
Now, we are going to study the impact of the
introduction of the third option on top of the collar.
Speculative 3-Way Collar
Lets start with the speculative 3-way. Lets assume
that the producer thinks that prices are going to trade
in a narrow range and it is very unlikely that gas
84
Figure 1: Revenues Before & After Hedging With Costless Collar ($4.30 floor & $4.55 ceiling)
Source: NQuantX
Figure 2: Speculative 3-Way Collar P&L
Source: NQuantX
... most firms that use 3-way collars tend to choose
the speculative type, even though we will show it is
not a good fit for most hedging programmes
Revenues Before Hedging Revenues After Hedging
Costless Collar Short Call @ 4.55 Long Put @ 4.3
3-Way Collar Short Call @ 4.55 Long Put @ 4.3 Short Put @ 4.2
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Gas Price ($/MMBTU)
Gas Price ($/MMBTU)
3-WAY COLLARS
prices will fall below $4.20, where they think there is a
technical support level. In addition to buying the $4.30
put and selling the $4.55 call, the producer decides to
sell the $4.20 put and collect $0.17 per MMBTU.
The payoff from the 3-way collar under different
settlement prices for the underlying is shown in
Figure 2 . If we analyse the different price regions and
the associated payoff of the 3-way collar we can see the
following:

If prices are above $4.55, the producer would have to


pay the counterparty for the difference. Effectively
the producer is giving away all the upside above
that strike.

If prices stay between $4.55 and $4.30, all options


in the structure would expire OTM and therefore
there would be no exchange of payments.

Between $4.30 and $4.20 the producer would


receive compensation from the counterparty.

Below $4.20 the maximum protection would be


$0.27 (including the overall premium received).
In Figure 3, we can see the revenues before and after
hedging as a function of final settlement prices. We
can see that if price were to collapse the producer has
very limited protection, while if prices were to increase
substantially the producer would experience heavy
losses on the 3-way structure.
Speculative 3-way collars can be an effective trading
strategy in certain market conditions, but many risk
managers believe that the use of speculative 3-way
collars as a purely hedging tool is highly questionable.
Conservative 3-Way
Lets look now at a very different strategy, which
involves purchasing a further OTM call instead of
selling the deeper OTM put. In addition to buying
Figure 3: Revenue Structure Under Different Price Scenarios
Before & After Hedging With Speculative 3-Way Collar
Source: NQuantX
June 2013 85
Figure 4: Conservative 3-Way Collar P&L
Source: NQuantX
Revenues Before Hedging Revenues After Hedging
3-Way Collar
Short Call @ 4.55 Long Put @ 4.3 Long Call @ 4.9
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Gas Price ($/MMBTU)
June 2013
3-WAY COLLARS
the $4.30 put and selling the $4.55 call, the producer
decides to buy the $4.90 call, which would require an
upfront payment of $0.11. We will see that producer
will have a much better hedge in the event of sharp
moves in the underlying.
If we analyse the different price regions and the
associated payoff of the 3-way collar (see Figure 4) we
can see the following:

If prices settled above $4.90, the worst-case potential


losses and margin calls from the sold $4.55 call in
the 3-way structure would be capped at $0.35 plus
the upfront cost of $0.11 per MMBTU. Effectively
the producer is retaining the upside beyond $4.90.

If prices stay between $4.55 and 4.90, the sold call


would pay off.

Between $4.30 and $4.20 all options in the structure


would expire OTM and therefore there would be no
exchange of payments.

If prices settled below $4.30, the purchased put


would entitle the producer to receive compensation
from the counterparty for the full difference
between the strike and the final settlement price.
In Figure 5, we can see the revenues for the producer
before and after hedging. It is important to notice the
large differences in the revenues after hedging between
the speculative 3-way (Figure 3) and the conservative
3-way. A summary of the speculative and conservative
3-way structure for producers is shown in Table 3.
3-Way Structures As Protection Against
Operational & Weather-Related Risks
Producers that actively hedge price risk may be
exposed to large losses in their hedge book that may
not be compensated by higher revenues on their
physical sales due to volumetric variability.
The risk of unexpected production shutdowns is
one of the main risks faced that energy producers
that use costless collars or linear instruments such as
futures, swaps and forwards for price protection. Some
examples include producers that hedge their expected
production margins such as refinery crack spreads or
power plant spark spreads.
In addition, operational risks
and market risks are often highly
interrelated. For example, a large
refinery shutting down because of
a hurricane is likely to put upward
pressure on regional product prices
and downward pressure on crude
oil prices as the refinery sells excess
crude inventory. As a result, the
costless collars used for hedging
would experience large losses that
would not be compensated by
higher production revenues.
86
Table 3: Speculative vs. Conservative Producer 3-Way Collar
Speculative Conservative
Producer Buy $4.30 Put Buy $4.30 Put
Sell $4.55 Call Sell $4.55 Call
Sell $4.20 Put Buy $4.90 Call
Risks Protection against price
decreases only up to 4.20.
Unlimited MtM losses and
potential magin calls
Protection against any price fall.
MtM losses and potential margin
requirements from hedging
program limited
Premium Upfront premium of $.17 paid Upfront premium of $0.11 received
Source: NQuantX
Figure 5: Revenue Structure Under Different Price Scenarios
Before & After Hedging With Conservative 3-Way Collar
Source: NQuantX
... deep OTM calls are an efficient hedge
against volumetric uncertainty ...
Revenues Before Hedging Revenues After Hedging
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Gas Price ($/MMBTU)
3-WAY COLLARS
Agricultural producers are also exposed to significant
volumetric variability in their production because of
unexpected weather conditions.
If a hedge strategy is based on expected production
levels, and the actual production levels end up being
significantly lower than the hedged volume, the hedge
book fluctuations will be considerably larger than
the changes in production revenues. In fact, lower
production levels are often associated with higher
market prices which would result in losses on the hedge
book that would not be compensated by overall higher
production revenues.
An effective way for producers to hedge this operational
and market risk exposure is to use conservative 3-way
structures. By buying the deep out-of-the-money calls,
producers can set a cap on the maximum losses they
may experience in the hedge structure regardless of
actual production levels. Therefore, deep OTM calls are
an efficient hedge against volumetric uncertainty.
Summary
To summarize, adding a third option into a costless
collars materially changes the dynamics of the
structure. Understanding the implications of buying
the deep OTM call instead of selling the deep OTM put
is critical for risk managers and senior management
teams of energy and commodity producers.
Some hedge programmes are designed based on
strong market views, and may opt for the speculative
3-way in some instances, but the risks should be clearly
understood and communicated.
However, for hedging programmes where the main
goal is price protection and the objectives are to insure
against extreme price moves and limit the potential
hedging losses, the conservative 3-way is a much
better fit, even though it involves a relatively small
upfront cost.

Carlos Blanco is Managing Director of NQuantX LLC


(carlos@nquantx.com), a financial engineering firm
that develops decision-support software for energy
and commodity trading and hedging, as well as
valuation and risk measurement of derivatives, long
term contracts and physical assets.
He is a faculty member of the Oxford Princeton
Programme, where he heads the Energy Derivatives
Pricing, Hedging and Risk Management Certificate
courses (DPH), as well as other courses on energy
trading and risk management.
www.oxfordprinceton.com
www.nquantx.com
... for hedging programmes where the
main goal is price protection ... the
conservative 3-way is a much better fit
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