Unintended Contract Options: Unexpected Ways to Lose.

Plant engineers and commercial managers may think that put and call options are only for rocket-scientist traders.  Nonetheless, they will be surprised to learn how much the unconscious granting and taking of options, particularly in a commodity price environment, affects their profitability.    When such optionality is incorporated into their commercial agreements it’s not always easy to diagnose.  And if they’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 are familiar. 

1. 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, Germany surprises markets with strong economic data, 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 tonne worse than your sale price.

   
   

2. You are a stainless steel producer and next month’s sales surcharge is 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 exercises his option. In an up-and-down nickel price world your sale prices are either lower than your supply costs, or you are left with high-priced unsold inventory.

   
   

3. You are a copper smelter with a long-term concentrate contract in which the price is established as the average of the month prior to actual shipment as determined by the vessel sailing date. 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.

   
   

4. You are a cable producer and you price the aluminum content of your product at the average CME 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. 

   
   

5. You are a zinc miner selling concentrates and have granted your smelter customer zinc price participation above a certain benchmark. In return, he gives you a rebate for prices below another benchmark.  You have effectively granted each other call and put options. The market value of these options may not be equal however, and the difference 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.

   
   

6. 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 tonne. 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, and 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 holds.  Understand your exposure to embedded commercial options – or be prepared to be squeezed.