Swaptions – Funny Name, Useful Tool

The actual deployment of capital seldom matches management’s plans as laid out at the beginning of the year. Even when things go according to plan, market prices may shift substantially from the time you commit to a project, raise money, and eventually begin generating revenue on the investment.

The exaggerated uncertainty around cash flows caused by operational delays makes risk management especially difficult. Standard hedging products, such as vanilla swaps and options, may not fit your budget or risk tolerance in this environment – especially if you can’t count on production starting as planned – but you may miss an important opportunity to generate returns. A swaption might be the right tool to manage risk given this uncertainty.

For example, an Exploration and Production company intends to drill multiple wells during 2022, based on the Jan 1 forward average price of $65. Their plan anticipates drilling at least one well in the 4Q. By Apr 1, prices have risen substantially relative to plan. The average forward price for the balance of the year is now $95. Management is keen to commit to the balance of its plan, but has seen plenty of risk, both in terms of price and operations. Looking at the price of oil for 4Q22, they see it has traded as high as $96 and as low as $70. At the same time, delays are piling up and competition for materials and labor is fierce, driving up prices. The hedging counterparty shows them a bid on a short swap of $95, but they are hesitant to commit to a fixed price swap today and give up potentially higher prices, disappointing investors. They also asked for the cost of buying a $90 put for the 4Q and their counterparty shows them a $10 premium. They deem this to be too expensive to pay up front, especially considering they are unsure whether they will drill the well on time or under the current cost assumptions. Finally, they consider a swaption.

The swaption expires on Sept 30 and provides the company with the right to enter into a short swap at $90, if the market price of oil for 4Q22 falls below $90 on/before then. It is a compromise between a traditional put and an outright commitment to the swap, allowing the company to maintain its plan to drill based on the current forward price, without sacrificing upside. Because the company owns the right to the swap at $90, without the obligation to use it, they’ve effectively delayed the decision to hedge until September, when they’ll have full view of market conditions for 4Q22, buying time by locking in a supportive price.

Despite the funny name, swaptions are useful in scenarios where timing and operations are uncertain. Given the recent uncertainty E&P managers are facing in executing their drilling plans, it is a tool worth considering alongside standard hedging instruments to mitigate price risk down the curve. I have used them to manage expected commodity purchases and to protect assets during transactions. Call me to discuss how to employ them as part of your risk management portfolio.

Definitions:

Swaptions

Swaptions are options on swaps or other derivatives. Similar to standard options, the buyer pays a premium for the right to exercise the contract on/before expiry. The buyer has the right to enter into the underlying instrument at an agreed-upon price/strike, tenure, and settlement procedure. If the swaption is on another option, this includes premium to be paid. Swaptions typically expire before the effective start date of the underlying instrument. Also similar to standard options, if the position is out of the money at expiry, the swaption buyer only loses the premium paid.

Payer Swaption

Payer swaptions give the buyer the right to establish a long position in the underlying instrument – the right to pay a fixed price. If the price of the underlying instrument is above the swaption price, the buyer would exercise. If it is below, the buyer would give up premium paid.

Receiver Swaption

Receiver swaptions give the buyer the right to establish a short position in the underlying instrument. – the right to receive a fixed price. If the price of the underlying instrument is below the swaption price, the buyer would exercise. If it is above, the buyer would give up premium paid.