A. ignoring taxes, what will specialty’s profits be if oil prices in

(Hedging with forward ccontracts) The

Specialty Chemical Company operates a crude oil refinery located in New Iberia, LA.

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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 needs for one year hence.

Specifically, the firm’s analysts estimate that Specialty will need to purchase 1 million

barrels of crude oil at the end of the current year to provide the feed stock for its

refining needs for the coming year. The 1 million barrels of crude will be converted into

by-products at an average cost of $40 per barrel that Specialty expects to sell for

$170 million, or $170 per barrel of crude used. The current spot price of oil is $125 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 of $130 per barrel.

a. Ignoring taxes, what will Specialty’s profits be if oil prices in one year are as low as

$110 or as high as $150, 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 would

effectively lock in the firm’s cost of fuel today, thus hedging the risk of fluctuating

 

crude oil prices on the firm’s profits for the next year.

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