What is a Commodity Put Option?
A Commodity Put Option is a contract that grants the Producer the right but not the obligation to sell a specified quantity of a specified commodity to the Consumer, at a fixed price, on a stated future date.
The purpose of a Commodity Put Option is to place a minimum payment receipt on a known future sale of a commodity. It thereby limits the downside risk while maintaining the ability to trade at a higher spot rate if it occurs.
How does it work?
An oil Company knows they will have produced 500 barrels of oil in a year’s time. They do not want to pay for storage longer than necessary, but do not want to sell the oil for less than $105 a barrel. Therefore they buy a put option with a strike of $105, which means that if prices are below this level they will exercise the option and have the right to sell oil at $105 per barrel. But if the price is above the strike, (e.g. $108) they can allow the option to expire worthless and sell their barrels at the market rate.
- Provides the Producer with a minimum income
- Provides the Producer with the flexibility to benefit from high fuel rates should the spot price be higher than the Option strike at expiry
- Holder will incur a premium cost, usually paid up-front
- If fuel rates rise above the Option strike rate during the tenor of the option, the Producer may feel no value was received, as the option will expire worthless
Commodity Put Option example: