Costless Collar?

T?he widespread use of costless, or zero-premium, collars is a prime example of a systemic distortion caused by misalignment of banker/client (oil and gas producer) interests. Originally used by options traders as a speculative tool, costless collars have become a marketing bonanza for financial institutions offering commodity-price hedging services to E&P customers.

A closer examination of costless collars reveals the severe drawbacks of the application of this once-speculative derivative technique to the hedging of commodity-price risk, and the subtle incentives that have helped this strategy grow to become the No. 1 hedging “solution” pushed by financial institutions.

From a technical perspective, the strategy itself is benign. A costless collar is created when the purchase of out-of-the-money puts (down­side price protection) is financed dollar-for-dollar by the sale of out-of-the-money calls (upside participation), creating a synthetic short position in the underlying commodity. In the typical configuration, no premium changes hands at the initiation of the trade, thus the notion that the collar has no “cost.”

When combined with the natural commodity-price exposure carried by an E&P company, the resulting commodity-price-sensitivity impact can be graphed as a sideways “S.” That is, the E&P company gains downside protection (a price floor) in exchange for giving away upside participation (a price ceiling). In between the collar’s strikes, the company retains full exposure to commodity-price moves.

Option-floor-trading speculators were attracted to the zero-premium strategy because of the ability to gain significantly more gamma (acceleration) per unit of delta (velocity) exposure while mitigating theta (time decay). In layman’s terms, the trade did not lose value over time like a straight put purchase, required no initial capital outflow (zero premium) like a swap, but could generate greater leverage to an extreme move in the underlying commodity than a straight swap with equivalent initial risk.

Perceived disadvantages

The application of costless collars to hedging has been fueled by perceived disadvantages, which have been marketed aggressively, of the two primary alternative hedging strategies: selling forward, including futures, forwards and swaps; and buying puts.

While there is no initial premium required to execute a forward sale, a certain amount of performance collateral, or margin, must be maintained. Should underlying commodity prices increase, the value of the forward sale falls, requiring additional margin to be deposited.

While the forward sale provides instant and complete protection from commodity-price declines, in a rising price environment it not only prevents upside price participation, but also requires growing amounts of cash to be diverted from potentially high-return exploration and development capital-investment activities to sit idle, earning no more than risk-free cash returns.

During rising price environments, E&P companies that hedge are at a relative growth and earnings disadvantage compared with unhedged peers.

Buying puts addresses the strategic weakness of forward sales in a rising price environment. Upside price participation is retained, and no additional capital will be required. But puts require a premium to be paid by the purchaser to the seller. This upfront cost can be substantial, materially affecting the overall cost of production. An institution marketing costless collars would quickly point out that hedging systematically and exclusively with puts could be viewed like an additional tax or royalty, creating a permanent cost disadvantage for an E&P company relative to its peers.

Following the discussion of the drawbacks of forward sales and puts, a savvy financial marketer would open its glossy-papered pitch book to an “analysis” of costless collars. The analysis would highlight the following advantages of costless collars: no premium required, substantial upside participation, protection from a crash in pricing, and no need to post additional margin unless prices get outrageously high, in which case upside participation would more than cover any incremental margin demands.

The financial marketer (the banker, advisor or originator) would then turn and ask, “Why wouldn’t you enter into a costless collar? It doesn’t cost you anything. Your lenders want the downside protection. The stockholders don’t see an impact on current earnings and it gives you some upside participation. It’s a win-win!”

Two more slides

At this point, it’s fair to say the intermediary has been transformed from advisor to salesman. Although the pitch-book analysis is mathematically sound, and the fonts and formatting have been thoroughly vetted, the slides titled “Customized Solution” and “Analysis of Total Cost” may not have made it into the final draft. This may be entirely accidental or editorial, but surely the omission has nothing to do with the lucrative fees, commissions and trading spreads at stake.

Let’s take a deeper look at what those slides might say.

The traditional practice of customizing a derivative strategy into an optimal solution starts with the customer’s specific fundamental needs. Is the hedging of cash flow or value? Is there basis, volume, quality, credit, transportation and/or reservoir-integrity risk?

Is the hedging of a specific amount to satisfy creditor concerns?

?Hedging systematically and exclusively with puts could be viewed like an additional tax or royalty, creating a permanent cost disadvantage for an E&P company relative to its peers.

These inquiries pinpoint specific needs, in terms of the appropriate strike price, sensitivity, liquidity and duration of the hedge. Implementing an optimal hedge is therefore contingent on the ability to customize the solution to satisfy the customer’s need.

In contrast, to ensure a collar is “costless,” the downside strike price (floor) is set at a level relative to the proceeds that can be garnered by selling calls (price ceiling), factors determined by relative option pricing in the market. In the proper use of derivatives for hedging, optimal strike prices should be determined by internal company-specific factors, not by the mechanics of market-derived implied volatility.

While there is a tweak to the standard costless collar that permits adjustment to the strike price by breaking the equilibrium between the numbers of puts and calls bought and sold, respectively, this technique creates a hedge with a very different, and potentially dangerous, risk profile than a true costless collar. Thus, the costless collar is a one-size-fits-all tool that is highly unlikely to be an optimal solution for any specific company. It should now be clear why the compliance officer axed the slide titled “Customized Solution.”

The second missing section, “Analysis of Total Cost,” brings back memories of pre-Sarbanes-Oxley days in equity research. Then, a research report would typically need official sign-off from editorial and compliance as well as an unofficial nod from banking and capital markets before going to press. If a neophyte attempted to include slides discussing opaque or intrinsic costs that were not legally compelled, after the same neophyte was beaten with the turret phone in capital markets, a banker would shower diminutive profanities suggesting the topic was as damaging as a Sell rating.

Finally, a seasoned bystander would show pity, and rush the analyst off the trading floor and out of harm’s way into a barricaded conference room. There the analyst would be taught how one can’t possibly expect to sell billions of dollars of an instrument called a costless collar if including slides that talk about costs.

Post-Sarbanes-Oxley, those slides should cover two topics: implementation costs and intrinsic costs.

Implementation costs include transparent items, such as fees and commissions, as well as opaque items, such as liquidity spread and order bias. Relative to accessing vanilla instruments directly via Nymex and the IntercontinentalExchange (ICE), the complete and total lack of visibility into the construction and over-the-counter market-making action of the intermediary leaves the customer exposed to significant overall “slippage.” Moreover, in addition to increased slippage, for the service of creating a one-size-fits-all instrument, the typical fees and commission rates for a customized hedge tend to dwarf those associated with vanilla exchange-traded instruments. Thus, higher implementation cost needs to be highlighted in the revised pitch-book. Intrinsic costs include efficiency loss and value dilution. Efficiency loss can be characterized as the difference in hedging effectiveness achieved by using costless collars versus customized combinations of puts, calls and forwards. As there are multiple combinations of strike prices not available in a zero-premium format, it stands to reason that there also would be significant differences in coverage and exposure. Given volatile prices over time, the cumulative difference will have a material impact on the effectiveness of the solution. Thus, higher efficiency loss also needs to be highlighted in the revised pitch-book.

Misinterpretation cost

The most difficult intrinsic cost to conceptually tackle but that is in aggregate potentially more value-dilutive than all of the other costs combined, would be the almost-certain misinterpretation and potential misvaluation of component options embedded in a costless collar.

First, there is a misinterpretation of component-option valuation in a costless collar. Quants (“dark” traders) have long understood the impact of skew on options pricing. They have yet to boil it down into pitch-book format for the bankers. Skew is a quantitative description of the inability of put-call arbitrage to equalize implied volatility across varying strike prices.

That is, the cost of reciprocal options with strike prices equidistant above and below the current price may not be equal. In short, a call option $20 above market is not priced the same as a put option $20 below market. This potential for misinterpretation of skew is by no means academic—if the marketing pitch for costless collars instead said that one would have to sell $60 of upside to pay for $30 of downside, there might be few eager customers. Thus, the revised pitch book needs to highlight the potential value dilution caused by misinterpretation.

Second, there is potential for misvaluation of the component options in a costless collar. A market advocate would argue that, because the value of the calls and puts are determined by a competitive marketplace, the transaction would indeed be priced appropriately. A theoretical derivative analyst might also argue that put-call parity and Black-Scholes models based on normal distributions confirm the pricing accuracy of the transaction.

Yet, this is contrary to common sense and empirical commodity-price behavior. Oil and gas prices do not behave in line with a standardized quantitative model, let alone a normalized distribution. There is unique gap-risk (e.g., supply interruption, OPEC action) exhibited by physically produced and consumed energy.

While partially captured by skew (up or down bias) and leptokurtosis (fat-tail probability) statistics, the inclusion of intermittent, nonrandom, nonchaotic trend reinforcement (in the form of index participation and storage-arbitrage activities) totally undermines the validity and reliability of off-the-shelf quantitative option-pricing models, particularly the longer the duration or more extreme the strike price.

In addition to statistical-modeling error, the complete utility value (e.g., the value of bankruptcy avoidance) of out-of-the-money options (intellectually equivalent to catastrophic insurance) is by no means captured in standard, quantitative option-valuation models. Indeed, the likelihood that an independent E&P’s zero-premium collar is indeed cost-free is probably very, very small. Again, the revised pitch-book on costless collars needs to highlight potential value dilution caused by misvaluation.

Lack of customization, higher implementation costs, higher efficiency losses and potential value dilution via misinterpretation and misvaluation are concerns worth considering before hedging with costless collars.

One does not need to be a derivatives connoisseur to see the potential flaws of a costless-collar hedging strategy. Intuitively, hedging is no more than insurance on future commodity prices. Would one ever expect insurance for free? Costless collars are a huge mistake for most oil and gas producers.

Matthew Epstein is the managing member of Aremet Group LLC, an independent, strategic energy-advisory firm based in Greenwich, Connecticut. Prior to founding Aremet, he was an energy portfolio manager at Citadel Investment Group and Morgan Stanley Asset Management, and an energy-research analyst at Salomon and Lehman Brothers.