Question

It’s September 2015 and Apache is about to acquire a natural gas reserve at a price which translates to $1.75 per thousand cubic feet of reserves. It wants to establish a costless collar for January 2016 sales of 500B cubic feet of natural gas, using January put and call options.

One option contract is for 10,000 mmBtus, where mmBtu denotes 1 million British thermal units. Puts with a strike of $2.85/mmBtu have a premium of $0.168/mmBtu, while calls with a strike of $3.25/mmBtu cost almost the same, at $0.181/mmBtu.

1. Translate targeted sales into mmBtus, noting that mmBtu≈1000 cubic feet.
2. Construct a “nearly” costless collar with puts and calls. How many of each, long or short?
3. What is the total net cost or net income from this trade?
4. Net of options proceeds (but ignoring part c. cost/income), what price will Apache sell natural gas for in January, per thousand cubic feet? Explain.

Answer 1

Estimated sales=              500B cubic feet=              500,000,000,000             cubic feet

1 mmbtu=           1000 cubic feet               

1 cubic feet        0.001     mmbtu

500,000,000,000             cubic feet =        500,000,000,000*0.001 mmbtu

Estimated sales=                             500,000,000      mmbtu

                                            

Pricing= $1.75 / 1000 cubic feet reserve                 

Pricing= $1.75 / (1000 *0.001) mmbtu                    

Pricing= 1.75/ mmbtu                    

                                                                          

Costless collar                                 

                                            

Apache has a the gas reserves i.e. the underlying asset. For a party having the underlying asset, a more logical hedge protection would be to be able to sell the underlying at a fixed/ pre-determined cost in future. This can be achieved by buying a Put option. Currently, te puts are available with strike of $2.85/mmBtu whereas the spot price is $1.75/mmBtu. Hence, the puts are Out of Money. To reduce the cost of put options, a collar can be constructed by selling OTM call options. The currently available call options are with strike of $3.25/mmBtu.                                            

Position would be- Buy put option for premium of $0.168/mmBtu, and sell call option for premium of $0.181/mmBtu,                                     

Net cash flow per position= $0.181-$0.168= $0.013                                       

Cash flow is +ve which means that the net position is generating income from option premiums                                         

                                            

No of options to be purchased-                                

Quantity of underlying= 500,000,000      mmbtu

Quantity of 1 option contract=   10,000 mmbtu

No of option contracts= 500,000,000/10,000                      

               50,000               

                                            

Net position= Buy 50,000 put and sell 50,000 calls available to gain complete hedge by implementing costless collar                                    

                                            

Cash flow from 1 collar position=              $0.013                

Net cash flow = =0.013*50,000                 

               $650.00                            

Since the net cash flow is +ve, we are receiving cash from the collar.                                     

                                            

Apache has purchased a put option with strike price of $2.85/mmBtu. Hence, its minimum selling price is fixed. If the spot price of natural gas in Jan'16 is equal to or less than $2.85/mmBtu, Apache will sell the natural gas at a fixed price of $2.85/mmBtu. For any price above this strike price, the spot price will be more than strike price. Hence, the option will expire worthless and selling price will be equal to the spot price. If the spot price is above the call option strike price of $3.25/mmBtu, the Apache will still sell the natural gas at the spot price but the call option will be exercised as well. In this case, Apache will have to pay up the difference between the future spot price and call strike price of $2.85/mmBtu to the call option buyer. Hence, the maximum and minimum transaction price for Apache's price is fixed.