Call options are a means of minimising the price risk with acquiring allocation. Unlike Forwards, the purchaser retains the right as to whether they actually purchase the allocation allowing them the flexibility to monitor the allocation market.
Call options give a buyer, the right but not the obligation to buy a known volume of allocation at a known price at a specific date in the future. Just like a Forward contract, a Call option gives the buyer secure access to allocation at a known price in the future however, unlike a Forward, the buyer has the choice whether they exercise the option or let it lapse based on the prevailing market price.
How it works
The supplier of a Call Option agrees to sell an option to a purchaser to buy allocation water at a known price in the future. Each option is for the physical delivery of 1ML of water on a particular date in the future at a particular price (strike price). The supplier charges a non-refundable fee to the purchaser for each option, known as the option premium.
Each option has an expiry date, at which point the purchaser chooses whether to exercise the option, or let it lapse. If the purchaser wishes to exercise the option, they notify H2OX and pay the strike price. H2OX then ensure the agreed volume of water is transferred to the purchaser. If the purchaser decides to let the option lapse, the supplier keeps the option premium and the water.
A purchaser will generally exercise the option when the strike price is below the prevailing market price and generally let the option lapse when the strike price is above the prevailing market price.
The option premium will vary depending on several factors as determined by the supplier.
The main factors in determining option prices will include climate outlooks, prevailing allocation prices and the difference between the option premium and strike price.
What are the benefits/risks?
Call Options provide buyers with protection from rising water prices. By buying a Call Option, a buyer is protected when allocation prices rise above the combined price of the option premium and the strike price. The option premium can therefore be viewed as insurance premium against high water costs.
By purchasing a Call Option, the purchaser has secured a maximum price for their allocation should they exercise the option prior to the exercise date. If water prices fall, the buyer does not have to exercise the option and only the option premium is forfeited along with some administration fees. The total potential loss to the buyer is known when the contract is executed. This may be an advantage over other products in the market such as Forwards that commit the buyer to purchasing the water at the agreed price regardless of the prevailing market price, which could be well below the forward price.
The main risk in buying a Call Option is the counter party risk associated with the supplier. If the buyer decides to exercise the option, the supplier must meet their contractual obligations and deliver the allocation to the purchaser. This risk will be managed by H2OX through a margining process. Possible purchaser losses are limited to the value of the option premium. if the spot price is below the option price at the expiry date, the buyer of the option would be unlikely to exercise the option, and therefore lose the value of the option premium.
How does margining work?
Margining is a process by which the supplier of the Call Option is required to deposit collateral when the allocation spot price exceeds the value of the contracted strike price. The collateral can either be cash or an equivalent volume of allocation which will be held by H2OX in escrow.
Collateral is only deposited by the supplier if the prevailing allocation market price is above the exercise price. If the spot price falls below the exercise price, collateral will be returned to the supplier. The buyer is not required to provide collateral if the allocation price falls below the strike price as there is no obligation for them to exercise the option.
Collateral will be held in escrow in either a trade specific bank account, or a trade specific water account with both supplier and buyer registered as account holder. H2OX will determine the prevailing allocation price on a monthly basis. If the market price is higher than the exercise price in the Call Option contract, the supplier will need to deposit sufficient collateral to ensure the Call Option is covered.
This process means that in the event of a supplier default at the exercise date, the strike price combined with the collateral will be sufficient to ensure the volume of allocation in the contract can be delivered.
What is H2OX’s role?
H2OX has developed the contracts and procedures to implement Water Call Options in conjunction potential suppliers and buyers of these products.
H2OX is not the supplier or buyer of Call Options.
H2OX will broker arrangements between counterparties, administer the collateral and manage the delivery of allocation at the exercise date.
What are the fees?
H2OX will charge a 1.1% fee on the option premium (minimum of $0.55 per option) and the strike price should the option be exercised. An additional establishment fee of $275 will be charged to cover the movement of collateral in managing margin.