Collar Construction When a Lender and a Board Both Say No
A crude oil producer holds 120,000 barrels of December-deliverable inventory. Its lender covenant requires that at least 70% of that volume be hedged to a floor of $72.00 per barrel or better at all times. The board has separately resolved that no hedge may leave the producer net short at any strike by more than its physical inventory. December WTI futures trade at $78.00 (1,000 barrels per contract). December $75 puts are offered at $2.10 and December $82 calls at $1.40. The producer wants to pay no net premium. The $75 put has a delta of −0.38; the $82 call has a delta of +0.42. All positions are American-style options on futures.
1. Construct a zero-net-premium collar covering 100,000 barrels and test it against both constraints.
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Funding the puts
- Buy 100 puts: 100 × 1,000 × $2.10 = $210,000 cost
- Calls needed to fully fund: 210,000 ÷ (1,000 × 1.40) = 150 calls
Constraint test
- Upside sold: 150,000 barrels against 120,000 barrels of inventory
- Net short above $82: 30,000 barrels → violates the board resolution
So a true zero-cost collar at these strikes is unavailable at 1:1. The structure that would price to zero is precisely the one the board forbids - this is the judgement point, not the arithmetic.
Workable alternatives
| Structure | Premium | Floor | Cap | Constraint test |
|---|---|---|---|---|
| 1:1 collar, 100 puts / 100 calls | $70,000 debit ($0.70/bbl) | $74.30 | $82.00 | Passes both |
| Full-volume collar, 120 puts / 120 calls | $84,000 debit ($0.30/bbl) | $74.70 | $82.00 | Passes both; hedges 100% |
| Zero-cost with lower put strike | $0 | Below $75 | $82.00 | Covenant check: only if the strike nets ≥ $72 |
Recommendation: a 120-put/120-call collar for $84,000 (about 0.9% of notional) satisfies the lender's 84,000-barrel minimum, keeps the producer exactly flat against inventory, and leaves the floor at $74.70 - comfortably above the $72.00 covenant.
2. The producer instead considers buying puts only on all 120,000 barrels. What is the effective floor, and what does the −0.38 delta tell you about the protection actually delivered at inception?
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Premium and floor
- Cost: 120 × 1,000 × $2.10 = $252,000 = $2.10/bbl
- Effective floor: $75.00 − $2.10 = $72.90 - only $0.90 of cushion over the $72.00 covenant
Delta reality check
Delta-equivalent protection at inception = 120,000 × 0.38 = 45,600 barrels
Only about 38% of the volume behaves as hedged on day one. As the market falls the put moves toward delta −1.0 and coverage approaches 100%; as it rises, coverage decays toward zero and the premium is lost.
If the producer wants full delta cover now:
120,000 ÷ (0.38 × 1,000) = 315.8 → 316 puts, costing roughly $663,600
That is 2.6× the premium for protection the producer may not need, and it must be rebalanced as delta changes (a dynamic hedge with real transaction costs).
Judgement: the lender's covenant is a notional test and 120 puts satisfy it at $72.90; economically the producer is only partially hedged near the money. If the floor really must hold at $72 from day one, a collar (which buys protection with sold upside rather than with cash) is the more capital-efficient instrument - the trade-off is the cap at $82, which forfeits 120,000 × ($78 − $82 upside) if prices rally hard. Document the choice against the board's stated objective.
3. December futures settle at $85 and the short $82 calls are left unaddressed. Walk through the mechanics and the cash-flow consequences, and state what the producer must have arranged in advance.
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Mechanics
- Options on futures are American-style: the short calls may be exercised any time, not only at expiry. With futures at $85 the calls are $3 in the money and exercise is near-certain.
- Exercise is not settled in cash. It creates a short futures position at $82.00 in the producer's account, established the next business day, one contract per option (120 contracts = 120,000 barrels).
- The producer must then post futures margin and meet daily variation margin on that short while its physical sale has not yet settled - a classic timing mismatch.
- The short futures offsets inventory economically (sold at an effective $82), but the producer must deliver against, or offset, the futures position; delivery obligations follow the futures contract, not the physical inventory.
What must be arranged in advance
- A pre-arranged unwind or offset plan (buy back futures / roll) and sufficient cash or a bank facility for variation margin to $85 and beyond.
- Volume discipline: the original 100-contract collar left 20,000 barrels of inventory unhedged by the calls; had the producer sold 150 calls to fund a zero-cost collar, 30,000 barrels would have been naked short futures - an unlimited-risk position against a board resolution.
- Segregated margin capacity outside the hedging facility, and a documented authority for who unwinds assigned positions.
Assignment risk is the operational failure mode in producer hedging programs; the economics are usually fine, the cash management is what breaks.