The Specialty Chemical Company operates a crude oil refinery located in Geelong, Victoria. 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 need for one yar hence. Specifically, the firm’s analyst estimate that Specialty will need to purchase 1 million barrels of crude oil at the end of the current year to provide the feedstock 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 $20
1. The Specialty Chemical Company operates a crude oil refinery located in Geelong, Victoria.
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 need for one yar hence. Specifically,
the firm’s analyst estimate that Specialty will need to purchase 1 million barrels of crude oil at
the end of the current year to provide the feedstock 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 $20
per barrel, which Specialty expects to sell for $80 million, or $80 per barrel of crude used. The
current spot price of oil is $50 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 if $55 per
barrel.
Please answer the following questions using the information
Questions:
a. Ignoring tax, what will Specialty’s profit be if oil prices in one yar are as low as $45 or as high as $75,
assuming that the firm does not enter into the forward contract?
b. If the firm were to enter into the forward contract, demonstrate how this could effectively lock in the firm’ cost of
crude oil today, thus hedging the risk of fluctuating crude oil prices on the firm’s profit for the next year?
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