Question

It is May 15. An oil producer has negotiated a contract to sell 100,000 barrels of crude oil. The price in the contract is the spot price on August 15. The spot price on May 15 is $60 per barrel and the crude oil futures price for August delivery on the New York Mercantile Exchange (NYMEX) is $59 per barrel. Note that each futures contract on NYMEX is for the delivery of 1,000 barrels.

1. Explain how he can hedge against the oil price fluctuations?
2. Suppose that the spot price on August 15 proves to be is either $69 or $45 per barrel. Discuss about the effect of your hedging strategy at this spot price on August 15.

Answer 1

A) ans:

The oil producer will always fear if the oil price falls. He has negotiated to sell 100,000 barrels of crude. The transfer will happen after a month. So he is worried, about the price of crude after 1 month. The current crude price is $60 per barrel. He is not sure about the price after 1 month. So to hedge from this risk, he can fix a selling price of crude today in futures market.

The future price that is going is $59 per barrel.

One future contract consists of 1,000 barrels, so he needs to sell 100 contracts as he is planning to sell 100,000 barrels.

1 contract = 1,000 Barrels

100 Contracts = 100,000 Barrels

B) Ans: Considering the spot price on August 15 to be $69 per barrel.

THe oil producer will have to sell barrels at predetermined price of $59 per barrel. In market he could have sold at much higher price, that is $69 per barrel. So loss per barrel

= Market price - Future price

= $69 - $59

= $10

The contract was for 100,000 barrels, so total loss

= $10 * 100,000 Barrels

= $ 1,000,000

Considering the spot price on August 15 to be $45 per barrel.

Here the oil priducer made the right decision by fixing the selling price earlier. He will be selling the barrels at $59, while in market the price is much less, that is $45

profit = Future Price - Market price

= $59 - $45

= $14

So profit per barrel is $14, there are 100,000 barrels. Total profit

= $14 * 100,000

= $1,400,000