Design and Evaluation of Long Term Commodity Pricing Contracts

Window contracts and cost plus contracts are being used for managing risk in long term producer-processor contracting relationships. Window contracts place a floor price and a ceiling price on the value of the commodity to the producer. Cost plus contracts base the minimum price on the cost of inputs. These contracts can be decomposed into portfolios of specialized put and call options. Monte Carlo option valuation techniques evaluated the impact of different price process assumptions on the values in these contracts. The conclusions are that knowledge of the price process is very important. Mean reverting processes, where the mean is correctly identified, lead to lower valued implied options in both window and spread contracts. Different strike prices are required for different times to maturity if the value of floor price (put option) is to equal the value of the ceiling price (call option) for window contracts. The floor and ceiling prices for window contracts and the cost plus portion of spread contracts need to change with the expected delivery date. A contract covering 10 years of production cannot have one single set of window prices or spread cost plus components.