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State of Texas: “Crude oil protective puts by the State of Texas”

Texas, along with other governments, is becoming a big-time player in the commodities market.

But it’s not because they’ve become bored with their own lottery operations. Quite the contrary;

their goal is not to take risks, but to reduce them. If the word hedging does not yet appear in the

codification of government accounting standards, you can be certain that it will soon.

Texas uses commodity options to protect its tax revenues from sudden drops in the price of oil.

Texas expects to generate $500 million from its oil severance tax. For every barrel of the “black

gold” produced in the state, the Treasury receives 4.6 percent of the sales price. A sharp drop in

price, such as in 1986 when it nose-dived from almost $25.82 to 11.36, can play havoc with the

state’s budget.

To lock in a set price, the state is experimenting with oil options. Here’s how they work.

The State purchases put options on crude oil. Each option permits it to sell (or “put”) a

thousand (1,000) barrels of oil at an established (exercise) price to the party that sold the option

on a specified (exercise) date. If on the exercise date the market price of crude oil is below the

established price, then the option has value: the intrinsic value – the difference between the

established exercise price and the market price. The state either exercises the option or sells it in

the open market, thus making a “profit” and covering the cost of the oil itself. The greater the

decline in market price, the greater the gain to the state from the put.. If, however, the oil

market price on the specified date is above the established exercise price, then the option has no

value and the state will allow it to expire worthless. Its loss is limited to the amount that it paid to

acquire the option (the “premium” cost).

The Texas Treasury can be viewed as the de facto owner of 4.6 percent (the severance tax rate) of all the oil produced in the state. Therefore, for each 1,000 barrels of oil that it wants to protect against a decline in revenue, it must buy puts on 46 barrels.

Suppose that on June 1, the State buys puts on 100,000 barrels of oil, thereby protecting 2,173,913 barrels (100,000 divided by 4.6 percent). Since put contracts are written in units of 1,000 barrels, the State would be required to buy 100 contracts. Assume that on the date the puts are purchased the prevailing market price is S = $21 per barrel and that this is the price that the state wants to lock in for purposes of severance tax collection three months hence. Therefore it buys puts with X = $21 as the strike price and T = October 1 as the expiration date. The cost of each contract might be approximately $1,100 including commissions—$110,000 for the 100 contracts.

If, on the expiration date, the market value of oil has fallen to ST = $18 per barrel, then the market value of each contract can be expected to approximate $3,000 [($21-$18)(1,000)] barrels]-or $300,000 for the 100 contracts. This amount will be just sufficient to offset the loss on the severance tax revenue from the $3 per barrel price drop (2,173,913 barrels times $3 per barrel times the tax rate of 4.6 percent). The state will sell the options for the $300,000 and its net loss on the entire transaction will be $110,000, the cost of the options.

If on the expiration date, the price of oil is $21 or more, then the options will have no value and the state will be out the $110,000 that it paid for them. However, the state will still reap the benefits from the increased tax revenue owing to the rise in oil prices, and this additional revenue may be sufficient to offset all or at least a part of the option cost.

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