After dramatic increases in oil prices in the 1970s, the U.S. government funded several projects to create synthetic oil or natural gas from abundant U.S. supplies of coal and oil shale. Although the cost of producing such synthetic fuels at the time was greater than the price of oil, it was argued that the projects still could be justified for their insurance value because the cost of synthetic fuel would be essentially fixed while the price of oil was risky. Evaluate the synthetic fuel program as an option on fuel sources.
a. Is it a call or a put option?
b. What is the exercise price?
c. How would uncertainty in the future price of oil affect the amount the United States should have been willing to spend on such projects?