Crude Oil Weekly Option Example 3: Producer Hedge
A producer is required to hedge 70% of his supply on a monthly basis and is hedging his August 2019 production using WTI Futures. In the last week of July, the producer starts to see higher than expected yields in his wells and projects an increase in volume, leading to an underhedged position come August.
The producer decides to utilize short-dated Weekly put options to provide some price certainty around the expected increase in volume and retain his 70% hedging covenant while he finds a buyer.
To hedge his current expected production of 1,000,000 bbls and meet the 70% hedging requirement, the producer sells 700 Sep19 WTI Futures contracts (700,000 bbls). Late in July, well production is projected at 1,200,000 bbls, leaving 140,000 bbls unhedged (70% x 200,000 bbls).
The producer is worried about the impact of certain geopolitical and economic announcements set for the week of July 29, 2019 and implements a Weekly bear put spread strategy that expires August 9, 2019 to hedge downside price risk. The bear put spread includes selling a lower strike put option and buying a higher strike put option with the same expiry in order to hedge against bearish market expectations. By purchasing a put spread instead of an outright put, the producer reduces the cost of the options hedge.
Date: 7/29/2019
Sep19 WTI Futures Price: $56.00/bbl
Expected Physical Exposure: 140k bbls
Bear Put Spread Strategy:
Sell 140 Weekly Puts @ $53.00 for $0.20 premium
Buy 140 Weekly Puts @ $56.00 for $0.70 premium
From 7/29/2019 to 8/9/2019, Sep19 WTI Futures fall approximately 6% to $53.00/bbl due to additional U.S. tariffs on Chinese goods and bearish remarks from the Fed Chairman regarding the likelihood of future rate cuts. 70% of the producer’s additional well supply loses $420,000 in value after the two-week period but is offset by a $350,000 gain from the option strategy ($420,000 profit – $70,000 premium). The producer is now able to sell the additional 140,000 bbls at a net price of $55.50/bbl.
The producer can replicate this strategy each week throughout the month to maintain his 70% mandate.