When you have options, volatility is your friend

IMAGINE THAT, by some twist of fate, you become the ruler of an oil-rich state. A crash in the oil price has left a hole in its budget. You are forced to consider selling the kingdom’s assets. Among them is a mothballed oilfield in a remote part of the country—so remote that it costs $90 to retrieve each barrel of oil. That is above the prevailing price of $70 a barrel. Even so, you are advised to try to sell a licence to operate the field.

Who would buy such a licence? It is valuable only if a barrel of oil sells for at least $90. Yet there is always value in a right—if it carries no obligation. The greater the chance that prices will rise above $90, the more the licence can be sold for. The price will be higher if the licence is for a long period. Crucially, the price also depends on how changeable the oil price is. The more volatile, the likelier it is that it will hit a level where it is profitable to restart production.

Volatility is normally something to fear. People prefer a stable income to an erratic one, for instance, and they feel the same way about their wealth. In this regard, the jumpiness of stock prices is a source of discomfort. But where you have rights without obligations—options, in other words—things are different. Here, volatility is welcome.

Look closely, and the hypothetical oil licence...



via The Economist: Finance and economics Business Feeds

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