Question

Please help me to understand the following problem. A detailed excel worksheet and step by step solution is requested.

Problem:

Suppose you own the option to extract 1,000 barrels of oil from public land over the next two years. You are deciding whether to extract the oil immediately, allowing you to sell the oil for $20 per barrel, or to wait until next year to extract the oil and sell it then for an uncertain price. The extraction costs are $17 per barrel. The forward price is $20, and you know that oil prices next year will be either $15 per barrel or $25 per barrel, depending on demand conditions. Are you better off extracting the oil today or waiting one year? Explain how your answer might be different if prices next year are either more or less certain but have the same mean.

Answer 1

The approach to solving the above problem would be descriptive.

When I consider the mean price for next year with 0.5 probabilities for each, i.e moving to $25 or down to $ 15, the mean would be = 0.5 * $ 25 + 0.5 * $ 15 = $ 20.

Now the given spot price is $ 20. However, this is a sure event, without possibilities or involving RISK.

Cost of Extraction is $ 17. Looking at the expected return and the risk involved with almost the same pay-off and uncertainty, the favourable choice would be to enter into contract immediately i.e. for $ 20.

Also since it mentioned in the problem that mean would be same if pricing differs, then also the answer remains the same i.e. entering contract of $ 20. The risk factor or the standard deviation would increase as the value moves above $ 25.