Floor (Put) Option - Hedging Production Or Generation Price Risk
Wholesale natural gas producers or electricity generators primarily use this option; however, this option is also applicable to end-users who are both purchasers of energy commodities and who also have natural gas production or electricity generation capabilities ("end-user/commodity supplier"). Examples of such end-user/commodity suppliers include facilities that own natural gas wells or co-generate electricity. Thus, end-users/commodity suppliers produce energy for their own needs, buy shortfalls in requirements through the market, and sell any excess energy produced on the market. The buying and selling transactions are separately hedged using separate instruments. The Floor option applies to hedge the selling of the excess natural gas produced or electricity generated to the market. Thus, the end-user/commodity supplier may arrange for a cap option to hedge the buying of commodity and a floor option to hedge the selling of the produced commodity.

By purchasing a floor option for an upfront fee, the end-user obtains the right but not the obligation to sell the energy commodity at the floor strike price over a specified term. The floor option is triggered when the index market-clearing price falls below the floor strike price. With a financial floor the risk management supplier pays cash in settlement equal to the difference between the index clearing price and the floor strike price when the option is triggered. With a physical floor the risk management supplier buys the energy commodity at the floor strike price when the floor option is triggered. Thus, a floor option provides the end-user/commodity supplier with protection against falling prices triggered once the market falls below the floor strike price, but the end-user/commodity supplier retains the ability to benefit from rising prices. The floor option can be structured to provide "disaster insurance" by setting a low floor strike that requires low upfront premiums.

For example, consider an end-user/commodity supplier selling the excess energy commodity to the market at day ahead or real time prices. The end-user/commodity supplier wants to "put" a "floor" to ensure minimum earnings, yet retain the ability to take advantage of the market when prices are high. To do so, the end-user/commodity supplier would have to purchase a floor option for an upfront fee, consisting of a floor strike price per unit of commodity for a specified total quantity over a specified contract term. For example, strike at $2.00 per dekatherm of natural gas ("dth") for 100,000 dths over a one-year period with an upfront fee of $50,000. The end-user/commodity supplier will continue to sell the commodity at the floating market index price so long as the index price is higher than the floor strike price. If the market price floats below the floor strike price, then depending on the structure of the transaction, for example an optional exercise or automatic exercise, the end-user/commodity supplier exercises the floor or the floor is automatically exercised, and the end-user/commodity supplier continues in effect to receive floor value for the commodity sold. With a financial cap, the risk management supplier reimburses the end-user/commodity supplier for the difference between the floor strike price and the market; with a physical cap the risk manager physically purchases the commodity at the floor strike price.

Two-Way Collar - Hedging Commodity Requirements
A two-way collar sets a specific range of price protection. The end-user's energy commodity price remains within the price range of the "collar" price, so that the energy commodity's price will fluctuate to the extent of the "collar" price. A two-way collar is constructed by setting a cap, which is achieved by purchasing a call option, and setting a floor, which is achieved by selling a put option. Based on the end-user's unique needs for risk limitation and price protection, the collar band can be structured at any desirable width, so long as the market supports the sale and purchase of the call and put options necessary to construct a two-way collar. The cap provides protection against rising market index prices, but the floor limits the potential to take advantage market prices lower than the floor, creating a compressed band of price opportunities while dampening risk volatility. A two-way collar is commonly constructed as a "costless collar," which is achieved by establishing the collar bands at a cap strike price and floor strike price that result in exactly offsetting upfront fee payments; thus, the purchased cap (call) option is financed by selling the floor (put) option.

This risk management option is for an end-user interested in paying day ahead or real time index prices, with protection against large price spikes, and while retaining some flexibility to save when the market dips. The upper cap collar range functions as a hedge against adverse increasing prices, limiting the upside price movement risk to the extent of the cap strike price. By creating a range to the floor collar band, the end-user continues to benefit from decreasing market prices, but also loses the ability to benefit from prices falling lower than the floor band, with the lowest index price set at the floor strike price. This option can be structured with no upfront fee, and as a financial or physical hedge based on daily, monthly, or average reconciliation. For example, the end-user could execute a daily collar for 200,000 dekatherms per day with a $5.00 cap and $1.00 floor. The end-user's price floats with the index between the $5.00 and $1.00 per dekatherm range, with upside risk limited at $5.00 per dekatherm, but downside benefit potential limited at $1.00 per dekatherm.

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