(Related to Checkpoint 20.1) (Hedging with forward contracts) The Specialty Chemical Company operates a crude oil refinery located in New Iberia, Louisiana. 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.

a) $110 per barrel equals 20,000,000 gains

while %150 per barril equals 20,000,000 loss

b) by entering the fordward contract the firm will purchase the barrel at the market value of the moment but, the contract will give the difference to the firm when it is above that level thus, there is no risk of a higher cost)

If the price is below 130 dollars then, the firm will pay the difference to the other party. In both cases, the total cost for the millon barrels is $130,000,000 therefore, there is no risk on the fluctuation of the barrel of crude oil.

Explanation:

a) revenues - total cost = income

where cost can be explained as conversion csot and material cost.

170 million revenues - 40  conversion cost - 110 materials = 20 million gain

170 million revenues - 40  conversion cost - 150 materials = -20 million loss

Specialty Chemical company

                                              low spot rates($110)     high Spot rates (150)

selling price                             $170 million                $170 million

cost of sales( 1 million)            $110 million                 $150 million

profits                                       $60 million                 $20 million

b.  The forward exchange contract versus the current spot rate is not a wise decision and has a loss of $ 5 million [($125 - $13) * 1 million] if the oil was to be bought using the current spot rate, but the Hedge is for next year and if spot rates increases then the Hedge will be an asset. if the spot rate is lower than the hedge then it is an liability. Demonstration needs  actual spot rate for the date of oil purchase.

Explanation: