The POWER of Options In Everyday Life: Keeping the Lights on

On April 20th 2020, the May contracts for WTI went from $18 to -$37 (not a mistake that is a negative number) a barrel. That is correct- institutions SPENT MONEY to have their oil taken away. Why would it cost money to remove the very product your business sells? In this post I will explain how like a water tower, setting up infrastructure to capture the benefits of tail risk is ideal for scenarios that involve extreme events and essential commodities.

Storing commodities and distributing them costs money. Having no place to put excess inventory leads to a build up of supply and requires spare capacity to keep the oil until it can be sold. You may be thinking, so what? Oil won’t expire and doesn't need any special environmental conditions to prevent decay. In theory, the market should prevent negative prices from happening by causing production to slow until the current supply is exhausted or no longer needed.

This is partially true, however, in the situation that resulted in negative prices last year occurred while there was still demand for oil. While it can be curtailed and taken offline over years, production can not be stopped completely within a month.

Physical, futures and spot prices refer to the cost of buying and storing now, buying only in the future and buying only now.

This is further complicated from different types of oil (Brent and Crude) being priced using a separate benchmark. To add more confusion, crude can be broken down into unrefined and refined products: all with their own pricing and storage characteristics. Simply put, crude oil is best for long term storage and requires processing before entering pipelines. The refining process creates fuels and building materials/ plastics used by consumers. Along the value chain there is storage capacity, bottlenecks, geographical limitations and dynamic independent demand curves.

So how do options let us earn more with less risk? By letting us GO WITH THE FLOW or JUST SAY NO to whatever the current price of oil is at the point of expiration. Many hedging strategies focus on locking in a price with the use of Futures and Forwards. While it may appear reasonable to avoid paying a pesky fee (called the premium) this is an often fatal error. The premium giving you the right but NOT the obligation to buy or sell a contract at a specified price is your way of staying alive no matter what.

I would describe the process of selling premium similar to that of picking up quarters in front of a steamroller. (Not paying premiums can expose you to unlimited risk as a buyer and seller but is almost universally less risky than selling premium)

The cost of not being able to fuel an economy and pay national debt is very different than meeting a firms requirements or a city power plant staying on budget. That's why they primarily bought puts that have a $54–56 strike on Brent and $42 for their heavy crude benchmark worth a combined $1.4B in premiums. If $40 Billion dollars worth of exports were not hedged with the option to sell at least some of their capacity for an average of $49 per barrel, most of 2020 would be at best a partial loss each barrel sold. While the option to sell at higher prices when oil was low prevented a major default, not having the option to sell oil at higher prices than $55 in 2021 illustrates the downsides of sacrificing optionality for predictability in order to meet the demands of creditors.

As you can see from the illustration and examples, there are drawbacks with using financial instruments as the only means of giving yourself options. Two main factors are time and cost of premiums during volatile times. The goal with buying protective puts is to limit the cumulative costs of premiums while maximizing the duration of coverage. For reasons I will get into during later posts, the cost of longer (in months) contracts (protective puts) rises in a non-linear curve for a few years along the x-axis all else being equal. Deciding what length, strike price and when to buy the contracts is very challenging and must be done at the risk of current market conditions inflating premium costs due to any number of reasons. (Volatility makes it more expensive to buy premiums)

Now you may be skeptical again when it comes to using optionality to protect a portfolio, but here is where commodities deviate from equities. Unlike shares in a company, with oil the number of barrels available to trade and the ability to substitute oil from one company to another gives the seller of futures and options contracts the right to deliver a contract through pipelines instead of settle the transaction with cash. It also means an investor, country or company can choose to accept the black gold over cash if they have the infrastructure to do so. The ability to store oil for use and resale is an incredibly powerful tool for risk managers and offers several key benefits.

1. There is no expiration date on stored reserves. They can be kept until they are needed for fuel or they can be sold at a favorable price.
2. The oil can be sold directly, refined then sold or sold as a fixed asset along with infrastructure.
3. The oil can be used as collateral for selling calls, futures or forwards.
4. The oil can be used as fixed collateral for loans in fiat.
5. The spare capacity can be used to lift export prices (any time prices go bellow a threshold exports get diverted to storage) without permanently scaling back production.
6. The spare capacity can be used to lower import prices or domestic price spikes by substituting supply during production ramp up.
7. The cost of building storage is not a terminal loss and can be scaled, forecasted accurately and completed quickly. It also decreases when in the proximity of refineries, pipelines, ports or transportation hubs.
8. The cost of storage facilities can be offset easily after a few years of arbitrage and maintains resale value as an asset. Premiums are a re-occurring cost with no tangible or lasting benefits after expiration.
9. The option to convert the storage facility into cash, debt, a revenue stream or risk mitigation asset and back does not also prohibit the use of financial options at any point. In most cases it benefits from them.

One last note: The method for valuing options used by Mexico was Asian contracts. Rather than using the contract price at a point in time, such as for American and US options, the average price over the month is used instead.