How Venezuela Can Have Their $80 – $100 Crude Oil Price Band: A lesson on Collars
BusinessWeek reported that Venezuela wants to keep Crude Oil in a $80 and $100 price band. Producers can affect this price band with what are known as price collars using options on crude oil futures contracts.
Venezuelan Oil Minister Ramirez can create a collar around $80 and $100 to insure that Venezuela can transact their crude oil in this band for quite some time. Venezuela is the OPEC’s 6th largest producer.
If he wanted to create the 80/100 price band, he would do the following (prices based on today’s settlement):
Buy the July 8000 Put which settled at $1.64 and sell the 10000 Call which settled at $0.82. So, in this case, the collar would cost Venezuela $0.82 per collar or $820 each ($1.64 – $0.82). That’s the most they can lose – the price they pay.
[Decimals aren’t used on the strike prices, so 8000 means $80.00, 10000 means $100.00, and 9550 means $95.50.]
For $820 today, Venezuela can insure than they will receive no less than $80 per barrel, but in return for a lower cost of “insurance” they forsake any upside above $100 – that’s because they take in $0.82 for selling the 10000 Call. The option contracts are based upon futures prices and their standardized size of 1,000 barrels.
To take advantage of $100+ crude oil beyond what they collar, Venezuela can produce more crude oil OR only collar up part of their expected production in the first place. Venezuela is said to be “capped” above $100 because they’ve obligated themselves to deliver the crude at $100 via the Strike Price of the Call option.
Venezuela can do it even cheaper, however, if they were willing to forsake a lower cap – lower than $100. Such a strategy would be called a “zero-cost collar” as Venezuela would only have to post margin (hedger margin which is lower than investor margin since they produce crude).
In this case, they would purchase the July 8000 Put and sell the July 9550 Call. At today’s close, both options coincidentally settled at $1.64, so what they pay for one will be offset by the sale of the other, hence “zero-cost.”
In fact, Venezuela can do this out to July 2011 also (and way out on the calendar for that matter). The July 2011 8000 Put goes for $6.92 and the 10000 Call went off at $6.70 for a net debit of $0.22 per collar, or $220 for every 1,000 barrels.
If Venezuela (or any other crude oil producer) were willing to sell the 9900 Call (instead of the 10000 Call), they could get $7.01 at today’s close, making the collar trade a net credit of $0.09 per collar, $90 of income to put on the collar!
Admittedly, the bid-ask spreads on everything get wider the further you go out on the calendar. I’m not sure that Venezuela could actually get paid $90 to have this protection, b/c it might get “eaten” during the transaction, but you get the picture.
I’ve done a few interviews with guys who really know the option space very well. Listen to my podcast interview with Tony Saliba and read my Gold Spread analysis, and watch Victor Sperandeo on Implied Volatility.
Question for my students: Who could be on the other side of any of these trades, and what is their market posture for crude oil?
All prices came from the CME Group and their awesome site.