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Finding hidden treasure is delightful. What’s more surprising is when these potential riches are hidden in plain sight in your physical procurement contracts. Unlocking this revenue requires some understanding of how to trade options, but the reward could provide you with a more optimized procurement strategy.
As a producer or consumer of physical commodities, you likely engage in procurement or sales with physical contracts tied to a physical benchmark.
In many instances, each party might request specific criteria written into a physical contract that will allow them to mitigate price risk and avoid an unforeseen situation. These criteria act as an insurance policy.
An insurance policy is similar in many ways to an option. You pay a premium for a specific payout. Before describing how these embedded physical contract options can be monetized, discussing how commodity indexes are used in physical contracts might be helpful.
A commodity index is typically embedded in physical contracts through a pricing mechanism. In physical contracts, commodities, such as lithium hydroxide or lithium carbonate, are traded based on their underlying index, which serves as a benchmark for pricing and settlement. The index represents the average value of trades that occurred in the market over a specific period.
When a commodity index is embedded in a physical contract, the contract’s pricing or settlement is tied to the index’s average price. This linkage allows parties involved in the contract to have exposure to the overall movement of the commodities represented by the index.
For example, if you have a physical contract for purchasing lithium hydroxide, instead of fixing the price solely based on the spot price of lithium, you could use a commodity index like the Fastmarkets lithium hydroxide monohydrate 56.5% LiOH.H2O min, battery grade, spot price cif China, Japan & Korea, $/kg as a reference. The contract’s terms might stipulate that the price will be a certain percentage above or below the index’s value at the time of settlement to incorporate transportation duties or taxes.
By using a commodity index in physical contracts, participants access a standardized pricing mechanism that reflects the overall market conditions for a particular commodity.
Discussing a theoretical case study helps describe the potential monetization of embedded physical contract options.
Cathode Corporation ABC agreed to purchase lithium hydroxide from New Energy Production Company XYZ. The deal stated that the price Cathode Corporation ABC would pay New Energy Production Company XYZ each month would be based on the previous month’s average price of Fastmarkets lithium hydroxide index. Cathode Corporation ABC would purchase the same volume each month during the contract’s life, but the average monthly price could not exceed 105% of the prior month’s price.
The clause in the contract that capped the price that Cathode Corporation ABC will pay per month is an option. No matter how high lithium hydroxide prices move during the current month, Cathode Corporation ABC can purchase lithium hydroxide at the prior month’s rate plus 5%.
Cathode Corporation ABC performed some analysis using historical Fastmarkets lithium hydroxide prices. They saw that during the past five years, there was a lot of volatility in the monthly average price of lithium hydroxide. Still, only 23% of the months had month-over-month changes that were more than 5%, and 10% of the months had moves that were greater than 10%. The cap in the price acts like an insurance policy that is embedded in the physical contract.
One of the benefits of having caps or floors embedded in a physical contract is that they can be monetized by selling them to another counterparty. If you sell the cap or a floor, you will no longer be insured but receive a premium.
The option premiums are based on several factors. The most fundamental variables include the current price of the underlying asset and the specified price (the strike price) at which the option holder has the right to buy (in the case of a call option) or sell (in the case of a put option) the underlying asset.
The remaining time until the option contract expires and volatility, which is a measure of how much the price of the underlying asset fluctuates.
Higher volatility generally leads to higher option prices because the option is more likely to be profitable.
Additionally, the rate of return without any price risk is typically derived from government bonds or similar instruments. It affects the cost of holding the underlying asset and is used in some option pricing models.
Cathode Corporation ABC has to determine if the cap is worth holding or if receiving cash would be more beneficial. For example, if you can pass the price on to your customers, you might not need the cap and be willing to sell it. The cap Cathode company owns as part of their physical contract is a form of commodity hedging.
An alternative strategy might be to hold only part of the insurance. Cathode Corp might decide to sell a cap that is 10% out of the money to receive some options premium but still be protected if the price of lithium hydroxide rises by more than 5% and up to 10% month over month. This options strategy is called a call spread, a partial insurance policy. The same concept can be used for floors.
In this theoretical payout profile, where the current price of lithium hydroxide is $18/KG, Cathode Corporation ABC might receive $0.30 of premium by selling a 10% out-of-the-money call options and have protection from $19/KG (5% out of the money, which is embedded in their physical contract) to $20/KG (which is 10% out of the money). Above $20/KG, they would not have any protection if the price rose more than 10% during a month.
In this theoretical payout profile, where the current price of lithium hydroxide is $18/KG, New Energy Mining Corporation XYZ might receive $0.30 of premium by selling a 10% out-of-the-money put options and have protection from $17/KG (5% out of the money) to $16/KG (10% out of the money). Below $16/KG, they would not have any protection if the price declines by more than 10% during a month.
While caps and floors might be popular in physical contracts, other options have names such as look-back pricing, extendables, escalators or de-escalators. You might find wording describing the right to extend your purchase at a specific price. The value of these embedded options can be monetized if you have an idea of their value and have a willing counterpart who will purchase these options.
The upshot is that an embedded option within your physical contract has a monetary value. It’s essential to understand options to monetize this value and have someone to pay for the option. While each option is unique, you might find a counterpart willing to purchase your embedded option and provide you with a premium that will allow you to unlock some of its value.
If you are interested in determining the value of your embedded options or learning more about hedging, feel free to contact our risk solutions team.