Unintended Contract Options: Seven Ways to Lose
Plant engineers and commercial managers may be forgiven for thinking that learning about delta and gamma risk is one of those courses a busy person doesn’t have to take. Nonetheless you will be surprised to learn how much the unconscious granting and taking of options, particularly in a commodity price environment, can affect your profitability. When such optionality is incorporated into your commercial agreements it’s not always easy to diagnose. And if you’re on the wrong side of it, in just one bad day it can bolt untethered through the gate and morph into runaway losses. Negotiator beware, vigilance is essential. See if any of our examples seem familiar.
- You are a European copper widget maker and you give your customer a firm quote based on the then LME price of copper in Euros and leave him a few hours to consider it before placing the order – you grant him an option. Meantime Switzerland revalues its currency, the Euro price of copper on the LME shoots up, he places the order and you have to buy the hedge at 110 Euros per ton worse than your sale price.
- You are a stainless steel producer and next month’s sales are based on last month’s nickel price. If the price goes down your customer waits until next month to order, and if it goes up his order is double his consumption – he takes an option. In an up-and-down nickel price world your sale prices are constantly lower than your supply costs, and in a topical price decline you are left with high priced unsold inventory.
- You are a zinc mine selling concentrate to a dealer and, in return for getting a slightly lower Treatment Charge, you grant him a quarterly option to price the purchase in a Quotational Period either before or after the delivery date. Whether the LME price goes up or down he will know it, and will price the purchase in his best interest. You lose much more than the TC improvement.
- You are an aluminum smelter with a long term alumina contract in which the price is established as the average of the month prior to actual shipment as determined by the sailing date of the vessel. The shipment is arranged by the seller so you have implicitly granted him a pricing option. You should not be surprised if most shipments take place around the month-end and – miraculously – the sailing date falls in the higher priced month.
- You are a US cable producer and you price the copper content of your product at the average COMEX price of the month of shipment. Your customers give orders for shipment in the week after the order is placed. They have implicitly taken a one-month pricing option, so in a rising market will book in the last week of the month, and in a falling market, in the first week of the next month.
- You are a zinc miner selling concentrates and have granted to your smelter customer price participation in zinc prices above a certain level. Usually he gives you a rebate for prices below an agreed level but you have effectively granted each other call and put options. The market value of these options may be wildly different which may get worse over time. Even if you hedged the options now the net adverse impact may be significantly greater than any differences in treatment charge you have been negotiating.
- You are an aluminum rolling mill selling product to a customer at a fixed price for one year forward, without a take-or-pay clause. You have effectively granted him a one-year call option in aluminum worth well over $100 per ton. If the price goes up he takes delivery and if it goes down he cancels. You take the loss.
These are all examples from our experience. They are different from the typical look-back option (back-pricing) which you have been warned about, but the results are the same – a gain for the taker and a loss for the grantor. Each situation must be looked at with expert eyes but one simple rule is that if you make a firm offer of fixed tonnage and known price of a commodity to your customer you had better get an instant acceptance of both price and tonnage from him – or dust off those course studies in Black-Scholes valuations and start burning the midnight oil.