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Blue Sky Mining, an independent mining company, wants to protect a portion of its production from falling coal prices. However, Blue Sky currently is not in a position to pay a cash premium for this protection.
Current market prices are 100¢/MMBtu. In order to protect itself against a significant drop in coal prices, Blue Sky enters into a one-year physical collar agreement with Enron for one-half of its production.
Under this agreement, Blue Sky is protected with a floor price of 90¢/MMBtu. In exchange for this protection, Blue Sky agrees to limit its upside price potential with a price cap of 110¢/MMBtu.
During the life of the collar agreement:
- Blue Sky continues to sell coal to its normal sources at market prices as long as they remain within the collar.
- If prices move below the floor set by the collar, Blue Sky exercises its right to sell coal to Enron at 90¢/MMBtu. If prices rise above the cap set by the
collar, Enron exercises its right to buy coal at 110¢/MMBtu.
- Blue Sky has "paid" to protect a significant portion of its production by for-going some of its upside price potential. In exchange, Blue Sky has received the financial and management benefits associated with limiting downside price risk.
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