Texoil1

On October 15, 2005, Jane Midfield was wondering whether her

colleague Mark Brown was right. Jane and Mark were working in the
marketing department of Texoil, a trading firm specializing in the
marketing of oil products to retail concerns (such as gas stations and
heating oil distributors) in Texas. Texoil practice was to buy oil on the
spot market and sell it with a margin. As a consequence of soaring oil
prices in the past few months, prices charged to customers had
increased. Both Jane and Mark had had to endure complains from
customers unhappy with the prices that they had to pay.

Mark had observed that customers wanted price stability. He had

suggested offering contracts at a fixed price for several years and
hedging the firms risk using oil futures contracts. Jane was sceptical.
She had in mind the case of Metallgesellschaft, a German company
that had almost been bankrupt after losing more than $1 billion on its
oil futures portfolio. She didnt want Texoil to take undue risk. A
heated discussion had followed. You are the brainy one, told Mark.
Work out the numbers and come back.

The spot price of oil of $65 per barrel and the risk-free interest was
4% per annum with continuous compounding. Jane knew that oil was
costly to store and that there were benefits from holding the physical
asset (referred to as the convenience yield). Being an aficionado of
John Hull, she remembered the formula to calculate the forward price

F=Se(r+uy)T
where r is the interest rate, u the cost of storage and y the
convenience yield (both expressed as a constant proportion of the spot
price). On October 15, 2005, the difference between the storage
costs and the convenience yield was -2% (this means u y = -2% in the

1 The Case is prepared by Professor Andr Farber for classroom

discussion
 forward price equation).

The contract that Mark had conceived would involve delivering 1,000
barrels every six month for the next 2 years at a fixed price of $70
per barrel payable at delivery. Three price scenarios were considered:
stable price, oil price increases, oil price drops.

T=0 T=0.5 T=1 T=1.5 T=2

Scenario1 65 65 65 65 65

Scenario2 65 75 75 75 75

Scenario3 65 60 60 60 60

Now Jane was on her own. She wrote down her questions:

1. Calculate the forward (futures) prices of oil for each maturity (6

months, 1 year, 1.5 year and 2 years)

2. Calculate P/L (Profit/Loss) for each scenario if the contract is hedged

with forwards.

3. Calculate P/L for each scenario if the contract is hedged with futures
(to avoid tedious calculation, assume that marking to market is
semiannual).

4. Suppose that only 6-month futures contracts are traded. Would it be

possible to implement an effective hedge?

5. What other risks should be considered?