The pseudo “zero cost” collar

While reading the Sri Lankan Sunday Times from last weekend I happened to come across an article relating to a bit of trouble the Ceylon Petroleum Corporation (CPC) has found itself in, relating to a hedging deal it had entered into with a consortia of banks.

It looks like the CPC had entered into a “zero cost collar” against the cost of oil. A zero cost collar is where you purchase a cap and simultaneously sell a floor. Effectively this ensures you only pay for the good in question within a certain range. What it gives you is an ability to freeze your cost for an agreed period of time.

For example, if oil is selling at $100 then you buy a cap from the bank, set at say $120, while selling a floor to the bank at say $90. The premium you have to pay the bank for buying the cap is offset by the premium you gain by selling the floor, which is where the “zero cost” bit is coming from. Effectively there is no payment needed upfront to enter into this transaction.

Obviously this will work well if the oil price stays within the given range, or goes up. However, if it falls, because you have sold a floor to the bank, you will have to pay the bank the difference between the floor and the current price. This is the situation the CPC is finding itself now in the midst of crashing oil prices. With no sign of oil prices rebounding, it is likely that many more millions will be paid to the banks before the deal expires.

To be fair to the CPC though, it was the general consensus in 2007 that high oil prices are here to stay. Top US investment bank Goldman Sachs were saying even as late as May 2008 that $200 a barrel is likely. So, entering into a hedging transaction might have sounded a good idea in such an environment.

Moral of the story, zero cost does not always mean zero cost, especially when it comes to derivatives.

~ by kajthurai on November 20, 2008.