Question

It is​ March, and Alberta Oil Refinery​ (AOR) has enough crude oil in inventory to continue refinery operations until September. AOR expects to need to purchase

400,000

barrels of oil in September. Management at AOR is concerned about oil price volatility. Futures contracts for September delivery are available with a futures price of

​$120

per barrel. Options contracts with a strike price of

​$120

and expiration in September are also​ available; puts cost

​$25

and calls cost

​$20.

Complete parts a through e.

a.

Describe how AOR can fully hedge using oil futures contracts.

A.

AOR can wait until prices rise in the future.

B.AOR can hedge by taking a short position in futures for

400,000

barrels of oil for September delivery.

C.AOR can hedge by taking an intermediate position in futures for

400,000

barrels of oil for September delivery.

D.AOR can hedge by taking a long position in futures for

400,000

barrels of oil for September delivery.

c. Describe how AOR can fully hedge using options.

A.AOR can sell the call options on

400,000

barrels of oil.

B.AOR can purchase the call options on

400,000

barrels of oil.

C.AOR can purchase the put options on

400,000

barrels of oil.

D.AOR can sell the put options on

400,000

barrels of oil.

d. Given the strategy in

c​,

what will be the total net amount paid by AOR​ (for all

400,000

​barrels) if the price of oil in September is as​ follows:

i.

​ $70

per​ barrel; ii.

​ $120

per​ barrel; iii.

​ $170

per barrel

i.

​ $70

per​ barrel; the total net amount paid by

AOR=​$nothing

million.

ii.

​ $120

per​ barrel; the total net amount paid by

AOR=​$nothing

million.

iii.

​ $170

per​ barrel; the total net amount paid by

AOR=​$nothing

million.

​(Round to the nearest million​ dollars.)

e. AOR has asked for your advice regarding hedging. Discuss how the each of the following individually will influence your advice.

i. AOR does not expect to have much cash available between April and August. In this​ case, AOR will choose to

▼

the futures hedge.

ii. AOR thinks that a drop in oil prices will occur if the economy goes into recession. There is a​ 33% chance this will happen. In a​ recession, demand for​ AOR's refined oil products will drop by half. In this​ case, AOR should choose

▼

the options hedge.

the futures hedge.

no hedge.

iii. AOR will experience extreme financial distress costs if its net revenues in August do not cover the net costs of oil purchased then. AOR net revenues are estimated to be

​$70

million. In this​ case, AOR should choose

▼

the options hedge.

no hedge.

the futures hedge.

iv. AOR will experience extreme financial distress costs if its net revenues in August do not cover the net costs of oil purchased then. AOR net revenues are estimated to be​ $50 million. In this​ case, AOR should choose

▼

the options hedge.

no hedge.

the futures hedge.

v. AOR can pass along any price increases in oil by increasing the prices of its refined products. In this​ case, AOR should choose

▼

the options hedge.

the futures hedge.

no hedge.

Answer 1

a). Since AOR will need to purchase 400,000 barrels of oil in September, it can fully hedge the purchase by buying futures contracts. (Option D)

c). AOR can hedge the purchase using options by purchasing the call options on 400,000 barrels of oil. (Option B)

d-i). If the price is $70 per barrel then call option will not be exercised (as the oil can be bought at $70 per barrel in the open market compared to the call option strike price of $120) so net amount paid by AOR will be the cost of the call option which is

$20 per barrel*number of barrels = 20*400,000 = 8 million

ii). If the price is $120 per barrel then oil can be purchased either in the open market or using the call since price will be the same, so net amount paid remains 8 million.

iii). If open market price reaches $170 per barrel then the call option will be exercised and net amount paid will be

strike price*number of barrels + cost of buying the call options = 120*400,000 + 8,000,000 = 56 million

Note: Sub-part (b) is missing.