The specialty chemical Company operates a crude oil refinery located in New Iber
ID: 2698547 • Letter: T
Question
The specialty chemical Company operates a crude oil refinery located in New Iberia, LA. The company refines crude oil and sells the by-products to companies that make plastic bottles and jugs. The firm is currently planning for its refining needs for one year hence. Specifically, the firms analysts estimate that specialty will need to purchase 1 millionbarrels of crude oil at the end of of the current year to provide the feed stock for its refining needs for the coming year. The 1 million barrels of crude oil will be converted into by products at an average cost of $30 per barrel that Specialty expects to sell for $175 million, or $175 per barrel of crude used. The current spot price of oil is $120 per barrel and Specialty has been offered a forward contract by its investment banker to purchase the needed oil for a delivery price in one year of $125 per barrel.
A. Ignoring taxes, what will Specialty's profits be if oil prices in one year are as low as $105 or as high as $145, assuming that the firm does not enter into the forward contract?
B. If the firm were to enter into forward contract, demonstrate how this would be effectively lock in the firm's cost of fuel today, thus hedging the risk of fluctuating crude oil prices on the firm's profits for the next year.
A. Ignoring taxes, what will specialty's profits be if oil prices in one year are as low as $105 or as high as $145, assuming that the firm does not enter into forward contract? Round to the nearest dollar.
Price of Oil/ bbl Unhedged Annual Profits
$105 _________
$110 _________
$115 _________
$120 _________
$125 _________
$130 _________
$135 _________
$140 _________
$145 _________
Explanation / Answer
Assuming that the firm does not enter into the forward contract
Unhedged Annual Profits for the price of oil/bbl if the prices are $190 - Oil Price in 1 year.
For the range of oil prices you have provided, the profit will be $105, $110, 115, $115, $120, $125, $130, $135, $140 respectively.
If the firm believes that the oil price is going to be above $140/barrel in one year, it should go into the forward contract to lock the price at $140/barrel. Then if the price goes above $140, they can still purchase the oil at their agree-upon delivery price of $140. This contract helps the firm hedge against oil price fluctuation and locks their profit at $175-$145 = $30/barrel.
Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.