It is March, and Alberta Oil Refinery Ltd (AOR) has enough crude oil in inventory to continue refinery operations until September. AOR expects to need to purchase 500,000 barrels of oil in September. Management at AOR is concerned about oil price volatility. Futures contracts for September delivery are available with a futures price of $110 per barrel. Options contracts with a strike price of $110 and expiration in September are also available; puts cost $25 and calls cost $20.
a. Describe how AOR can fully hedge using oil futures contracts.
b. Given the strategy in (a), what will be the total net amount paid by AOR (for all 500,000 barrels) if the price of oil in September is as follows:
i. $60 per barrel
ii. $110 per barrel
iii. $160 per barrel
c. Describe how AOR can fully hedge using options.
d. Given the strategy in (c), what will be the total net amount paid by AOR (for all 500,000 barrels) if the price of oil in September is as follows:
i. $60 per barrel
ii. $110 per barrel
iii. $160 per barrel
e. AOR has asked for your advice regarding hedging. Discuss how the each of the following individually will influence your advice.
i. AOR does not expect to have much cash available between April and August.
ii. AOR thinks that a drop in oil prices will occur if the economy goes into recession. There is a 33% chance this will happen. In a recession, demand for AOR's refined oil products will drop by half.
iii. AOR will experience extreme financial distress costs if its net revenues in August do not cover the net costs of oil purchased then. AOR net revenues are estimated to be $60 million.
iv. AOR will experience extreme financial distress costs if its net revenues in August do not cover the net costs of oil purchased then. AOR net revenues are estimated to be $50 million.
v. AOR can pass along any price increases in oil by increasing the prices of its refined products.