This post was originally written several years ago but has been updated several times since then as it is regularly referenced in other articles regarding oil and gas hedging with three-way collars i.e. Oil Crash Exposes New Risks for U.S. Shale Drillers.
Generally speaking, a three-way collar involves a producer buying a put option and selling a call option, just as they would do with a traditional collar, in order to establish a floor and ceiling. An additional step, or leg as it is known in the trading world, is what differentiates traditional collars and three-way collars. In the case of an oil and gas producer hedging with collars, the difference between a traditional collar (often a “costless” collar as the premium paid for the put option is offset with premium received by selling the call option), and a three-way collar is that the three-way collar also involves the producer selling a further out-of-the-money put option (also known as a subfloor). The net premium of a three-way collar varies based on the strike prices of each option leg as well as numerous variables which we’ve highlighted in various series e.g. The Laymen's Guide To Natural Gas Options.
So why do oil and gas producers often hedge with three-way collars? In essence a three-way collar can provide oil and gas producers with a "lower cost" (and in some case, revenue positive) collar due to the sale (short) of an additional, further out-of-the-money put option. However, as is nearly always the case, there is no free lunch. In the case of a three-way collar involving the sale of an addition put option, the producer is also taking on additional risk, specifically the risk that prices the lower priced put option will expire in-the-money due to significant decline in prices, as has been the case in recent months. For a strategy which is more likely to produce a low cost lunch, albeit still not free, see An Alternative Oil Hedging Strategy Using Three Way Collars.
As noted in the Bloomberg article mentioned above, some producers hedge with three-way collars because they are “sure” or “not concerned” about prices declining below a certain level i.e. the strike price of the second put option. Clearly, as evidenced by the various low price environments we have witnessed in the past ten years, taking such a view can be quite speculative in and of itself.
As an example, let's assume that when oil prices we still relatively high (i.e. 2014), a crude oil producer had hedged their 2016 production with a three-way collar comprised of a short $95 call option, a long $85 put option and an additional, short $75 put option. The graph below indicates how this three-way collar, as well as a traditional, producer costless collar, would perform in various price environments.
As the graph indicates, a three-way collar can be an ideal strategy in some price environments but, when prices decline significantly, as they have over the past couple years, it’s far from an ideal hedging strategy.
So, can three-way collars be a sound hedging strategy for oil and gas producers? The challenges faced by several of the producers highlighted in the Bloomberg article would suggest otherwise. However, in general, it's difficult to say until the options have expired. That being said, more often than not, when a producer hedges with a three-way collar of this sort, they are taking on additional, unnecessary exposure in exchange for what they perceive to be more advantageous strike prices or premium.
In summary, most producers which hedge with three-way collars are often taking a punt on the short put position, turning their hedge into a rather speculative trade. When initiating these strategies, many producers will claim that they "know" that prices won't decline enough for their short put position to move in-the-money. However, as we all know, that’s often not the case. Recall that many producers incurred large hedging losses from selling out-of-the-money put options, often as part of a three-way collar, when crude oil and natural gas prices collapsed in 2008-2009. Clearly many producers did not learn from the 2008-2009 collapse and are once again experiencing large hedging losses due to the recent price decline, many thanks to three-way collars.
Editor’s Note: The post was originally published in December 2010 and has been updated to provide additional information.