Question

I need some guidance on question 1c.

(1) (A) Between 2001 and 2011, the real (2018 US $) price of a barrel of oil rose at a rate of about 13% per year in real terms to around $124 per barrel in 2011, but the real price fell to $46 per barrel in 2016, before rebounding in 2018 to $71 per barrel. If prices continue increasing from their 2018 price of $71 per barrel through 2028 at a more modest rate of 7% year in real terms, what will be the price of oil in 2028? Assume these prices are for December 31 of each year.

(B) Suppose the price of gasoline in 2018 was $2.75 per gallon, and every $1 per barrel increase in the price of oil causes the price of gasoline to increase by $0.025 per gallon. If SouthWestern Ohio gasoline distribution company bought a forward contract for delivery of gasoline from Exxon in 2019 for $2.80 per gallon and in 2020 for $2.80 per gallon, based on your oil price projection in (A), will these contracts save them money? Be sure to show how you arrived at your answer.

(C) Suppose you are the operator of the East Lima International Refinery LLC, and you buy a call option for crude oil to refine in 2020. Your call option has a strike price of $59, with no option premium, and it expires on December 31, 2019. If prices rise as predicted above, will you make money on the call option? If so, how much? If not, what do you do on December 31, 2019 when the option expires?

Answer 1

1 (C) in part A question mentioned that price of oil was $71 in 2018 and will increase by 7% per year in following years.

so, price in December 31, 2019 will be $71*1.07 = $75.97.

Call option gives the right to its buyer to purchase the underlying asset of the option at strike price at option maturity. strike price is $59 and option will expire on December 31,2019 and spot price at that time will be $75.97.

so call option will make money because spot price is higher than strike price. if you buy the oil from market than you have to $75.97 whereas by exercising the option you can buy the same oil at $59.

so option payoff or profit = spot price at expiration - strike price = $75.97 - $59 = $16.97.

If one call option is for 1,000 barrels then profit would be $16.97*1,000 = $16,970.

If price on December 31, 2019 is not $75.97 and it is lower than strike price let's say $55 then it will be a loss to exercise the option and purchase the oil at strike price of $59. you can buy the same oil from market at $55.

As option gives its buyer a right but not a obligation, so you can let the option expire worthless at the maturity if spot price is lower than strike price. the only thing you will loose is option premium paid to purchase the option. but in this case option premium is zero, so you won't loose any money.