Question: Suppose you own the option to extract 1 000 barrels of
Suppose you own the option to extract 1,000 barrels of oil from public land over the next two years. You are deciding whether to extract the oil immediately, allowing you to sell the oil for $ 20 per barrel, or to wait until next year to extract the oil and sell it then for an uncertain price. The extraction costs are $ 17 per barrel. The forward price is $ 20, and you know that oil year will be either $ 15 per barrel or $ 25 per barrel, depending on demand conditions. Are you better off extracting the oil today or waiting one year? Explain how your answer might be different if prices next year are either more or less certain but have the same mean.
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