Using options theory for commodity spreads

Market risk for a real option asset can be effectively managed using a spread option model. Raymond Cheng and Walt Tyrrell demonstrate the enhanced risk-adjusted performance of optional refinery capacity with a historical back test

An asset is considered a real option when the profit-and-loss sensitivity to a commodity price or other market variable replicates that of an option contract and the owner of the asset has the right, but not the obligation, to use the asset. When the underlying exposure is the differential between the prices of two commodities, it can be further categorised as a spread option.

Types of spread option in the energy markets include:

Processing spreads - based on the price differences between