What is a Commodity Option?
A Commodity Call Option is a contract that grants the Consumer the right but the not the obligation to buy a specified quantity of a specified commodity from the Producer, at a fixed price, on a stated future date.
The purpose of a Commodity Call Option is to place a maximum cost on a known future purchase of a commodity. It thereby limits the downside cost while maintaining the ability to purchase at a lower rate if it occurs.
How does it work?
An oil consumer knows they will need to purchase 500 barrels of Brent crude in a year’s time. They do not want to pay more than $105 per barrel and do not want to pay for storage. Therefore they buy a call option with a strike of $105, which means that if oil prices are above this level, they exercise the option and only pay $105 per barrel. If the price is below the strike, (e.g. $100) they can allow the option to expire worthless and buy their barrels at the market rate.
- Provides the Consumer with a maximum cost
- Provides the Consumer with the flexibility to benefit from low fuel rates should the spot price be lower than the Option strike at expiry
- Consumer will incur a premium cost, usually paid up-front
- If fuel rates fail to rise above the Option strike rate during the tenor of the option, the Consumer may feel no value was received, as the option will expire worthless
Commodity Call Option example: