A Vilified Hedging Tool May Now Make Sense

October 29, 2020October 30th, 2020
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We hated three-way collars before hating was cool, but it’s time for forgiveness.

Three-way collars have really hurt some E&Ps. They offer only partial downside protection, but the benefit is they also maintain exposure at higher prices, if prices were to rise. When oil prices were higher than they are today, we encouraged clients to seek structures with better, more straightforward protection.

However, three-ways can make sense when prices are low and there is a fundamental reason why prices would not fall much further.

Let’s look at a construction that has recently been attainable. The three legs of this three-way collar would be:

  1. The Floor: Buy a put option at a strike price of $35 (cash outflow);
  2. The Subfloor: Sell a put option at a strike price of $25 (cash inflow); and
  3. The Cap: Sell a call option at a strike price of $49.20 (cash inflow).

Together, these three “legs” would sum to a zero-cost option structure. The swap for these tenors – we used the 2022 calendar year – was $39.97/Bbl at the time.

The chart above shows what the realized price an E&P would achieve, net of the hedges, at a variety of prices for WTI. Note that the producer is fully protected if WTI were to settle between $25 and $35. The realized price would be capped at $49.20.

Why not simply use a more traditional costless collar? Because, for the same tenor and floor of $35, the producer would be capped at a lower ceiling price — about $43.80/Bbl.

But we’re most concerned about what happens below $25, where the traditional costless collar would have provided absolute protection. That formula for the three-way is this: below a $25 settle in WTI, the holder of the three-way collar would receive market price (the settle) plus $10, which is the difference between the strike prices in bullets (1) and (2) above.

How possible is it that WTI could settle below $25/Bbl? It’s 100% possible, but in the past, has been uncommon.

The second chart (above) shows how many months of WTI CMA have actually settled below $25. It’s rare. This year, it happened in April (WTI futures settled below $25 in March, too). You probably blacked out during those months and don’t remember, and we aren’t judging you.

The previous sub-$25 settlements were in 2002. Therefore, even in the supply-rich, post-shale era, the U.S. producer-price benchmark of WTI CMA has remained over $25 except for one month this year.

Further, the market has seen that prices near $25 encourage temporary shut-ins of oil wells. If shut-ins occur, the reduced supply can support prices.

The three-way collar is a useful tool in providing partial downside protection, while preserving access to higher prices, should they rise. In this market, the Subfloor happens to be near both shut-in economics and the historical support level for WTI in its worst cases.

This hedging tactic is not appropriate for everyone. Contact the AEGIS strategy team to see how three-way collars would affect your risk and your portfolio.

Questions or comments, please contact us at view@aegis-energy.com

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