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Use of futures and options hedging strategies for an oil producer

Risk management

Question: You are the risk manager of an energy producing company. Your firm explores for and extracts crude oil. Your firm regularly produces approximately 50,000 barrels of oil monthly. You watch the energy markets closely and determine in early May 2011 that the current market price of $110 per barrel maybe a temporary peak. '

Requirement

A. Construct both a futures and options hedge to lock in this $110 bbl price for the next 6 months. Be certain to specify contracts, quantities, dates and all relevant and pertinent information for this hedge, including the actions required to complete the hedge at the end of the time horizon.

B. Discuss the advantages and disadvantages of the futures and options hedging strategies in the above question. Be sure to discuss the important aspects of the two hedging strategies including, but not limited to, the capital requirements

Solution Preview

Please see the attached Excel file.

Inventory 50,000 barrels
Purchase date June 15
Target loading date July 7 or 1st week

1 Futures contract 1,000 barrels

REQUIRED A
Futures
Number of contracts 50
Contract date May 1, 2011
Expiration date October 30, 2011
Spot market price $110
Strike price $110
Contract price $5,500,000
Margin $275,000

You would BUY 50 Futures Contracts (i.e. 50 x 1,000 barrels to cover 50,000 barrels)
locking in the price per barrel at $110. Moreover, you will have to put up a margin
requirement of $275,000.

At the expiration ...

Solution Summary

The use of futures and options hedging strategies for an oil produce is determined. The advantages and disadvantages of the futures and options hedging options strategies are given.

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