1. On October 5, Tatooine Oil committed to buy 10,000 barrels of oil for deliver

Question

1. On October 5, Tatooine Oil committed to buy 10,000 barrels of oil for delivery in December at a cost of $55 per barrel. Concerned that the price of oil might decrease, on October 10, the company purchased 10 December put option contracts with each contract trading 1,000 barrels of oil at a strike price of $56 per barrel. The option was settled on December 18. After processing the oil at a cost of $1 per barrel, 1/4 of the resulting inventory was sold for $60 per barrel on January 6. The time value of the option is excluded from the hedge effectiveness. Relevant values are as follows: Spot price per barrel Value of 1 option October 10 $55 $2,300 October 31 $56 $1,000 November 30 $55 $1,700 December 18 $54 $2,000 a. Identify the type of hedge b. Prepare all applicable entries for the months of October through January regarding the inventory and the hedging instrument assuming the hedge is qualified.

Explanation / Answer

Notes:

! Tatooine Oil is commited to buy 10000 barrles=10 contracts ( each contract=1000 barrels)

! This Oil company's profit margin can by this hedging will be increased as this has direct effect to crack spread(price difference between crude oil and refined product).

! This approach at the same time is for risk management at declining crude oil

! total profit from 10 put options= $2 from 10000( or 10 contract)-value of option in Oct 10(purchase of put)+value of option in settlement ( Dec 18) = $20000-$23000+$20000=$17000

Answers:

a. Here put option is ITM (In the money options) as strike price($56) is more than the current spot($55) price of the oil. This is type of a delta hedging, because it is hedging against price changes in its underlying.

b. Applicable entries with calculation-

Put Purchase 10/Oct Strike price 56 Spot 55 No of contracts 10 1 contract, no of Barrel 1000 Value/Option 2300 Total cost of 10 contracts 23000 Settled 18/Dec Spot price 54 Notional profit/barrel 2 Value/Option 2000 Total cost of 10 contracts 20000 Total profit from put option 2*10000-23000+20000 17000 Production or processing till 06/Jan Production cost/B $1 Total product 1/4 of 10000 BBL 2500 Selling cost= $54+$1 $55 Selling price $60 Profit from selling of 2500 barrles processed oil (60-55)*2500 12500 Total profit=put option profit+selling of processed oil 17000+12500 29500 Inventory 06/Jan Settled contract no=10 10000 Sold after processing 2500 Total inventory ( barrels) 10000-2500 7500

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