As energy trading and risk management advisors, we regularly receive inquiries regarding if, when and how a company might hedge their exposure to fuel prices with various strategies such as a three-way collar. For those of you who are not familiar with the terminology, a three-way collar is a typical collar, often costless, combined with the sale (short position) of another option. As an example, a traditional collar for a fuel consumer would combine the purchase of a call option (cap) and the sale of a put option (floor), which establish a ceiling and a floor, respectively. A consumer, three-way collar differs from the traditional collar as it includes the sale of an additional call option, thus creating a "capped" collar.
As an example, let's assume that an airline is looking at purchasing a December three-way collar on Brent crude oil. Based on the current market for December Brent crude oil futures, swaps and options prices, the airline decides that they want to execute a $55.00/$40.00 collar which will provide a $55.00 ceiling and a $40.00 floor. To keep the math simple, let's assume that the airline would pay a premium of $2.75/BBL for the $55.00 call and would receive $1.25/BBL for the $40.00 put, resulting in a net premium cost of $1.50/BBL. In order to reduce the cost of collar, the airline also decides to sell a $70.00/BBL call option for $0.50/BBL, which reduces the overall net cost of the three-way collar to $1.00/BBL.
For an explanation regarding why an airline might choose to hedge with Brent crude oil rather than WTI crude oil see Revisiting Energy Basis Risk.
To recap, the airline is now long a $55 call option, short a $40.00 put option and short an additional call option at $70.00. Let's now examine the potential results of this hedging structure if Brent crude oil were to average $25, $50 and $85/BBL, respectively.
Settlement at $25/BBL
At $20/BBL, the airline's $40 short put option is "in the money" to the tune of $15/BBL which means that the airline will incur a loss of $15/BBL on the short $40 put option position. Since both the $55 and $70 call options are both out-of- the-money they will both settle without any financial implication (gain or loss) to the airline. If we assume that the airline's actual cost of physical jet fuel is now also $25/BBL, the airline's net cost is $41/BBL which is comprised of $25 for the physical fuel, $15 for the loss associated with the short $40 put option and $1.00 for the upfront premium cost of the options.
Settlement at $50/BBL
At $50/BBL, all three options will settle out of the money which means that all of the options settle without any gain or loss to the airline. If we assume that the airline's actual cost of physical jet fuel is now also $50/BBL, the airline's net cost is $51.00/BBL, $50/BBL for the physical fuel plus $1.00 for option premiums.
Settlement at $85/BBL
At $85/BBL, both the $55 call option (long) and $70 call option (short) are in-the-money. Since the airline is long the $55 call option, this option produces a gain of $30/BBL ($85-$55). On the contrary, since the airline is short the $70 call option; they will incur a loss of $15/BBL ($85-$70) on this position. Also, since the $40 put option is out-of-the-money, this position settles without any financial implication to the airline. As a result, the three-way collar results in a net gain of $15/BBL ($30-$15). If we assume that the airline's actual cost of physical jet fuel is now also $85/BBL, the airline's net cost is $71.00/BBL which is comprised of the $85 for the physical fuel, a $15 net gain from the call options (which reduces the cost from $85 to $70) and $1.00 for the upfront premium of the options.
As these scenarios indicate, hedging with three-way collars is not without risk. More often than not an airline (or any fuel consumer) that "hedges" with three-way collars results is taking on additional, unnecessary exposure for what generally equates to a small reduction in option premium cost. While it can be argued that the additional exposure due to the sale of the second call option can be quantified and mitigated, the sale of the additional call option is, more often than not, an unjustified, lost opportunity cost relative to the reduced premium expense.
In summary, many fuel consumers which utilize three-way collars are often taking a punt on the additional, short option position (in this case the $70 call option), converting a relatively conservative hedging strategy (the original collar comprised of the $55 call option and $40 put option) into a rather speculative position. While many folks will be quick to tell you that they're confident that we won't see $85 or $25 crude oil anytime in the foreseeable future, there are more than a few market participants whom are still suffering from the “high” priced call options and/or low priced put options they sold ahead of the run up to $145 or the subsequent collapse to $35.
Last but not least, the risk of hedging with three-way collars isn't specific to consumers (end-users), oil and gas producers utilizing three way collars are also subject to what is often an unnecessary, ill-conceived risk associated with three-way collars which include the sale of an additional put option (subfloor). For more on hedging with three-way collars with respect to oil and gas producers, see Hedging Crude Oil & Natural Gas With Three-Way Collars.
While there is a time and place for hedging fuel price risk with three-way collars, doing so without fully understanding the implications of an extreme price move, higher or lower, can potentially lead to a cash flow crunch, or worse...