24. Hedging Heating Oil with Futures (LO4, CFA5) Heating oil futures contracts are traded on the New York Mercantile Exchange (NYM), a division of the CME Group. The standard contract size for heating oil futures is 42,000 gallons per contract. You have an inventory of 1.68 million gallons, and you want to construct a full hedge. Suppose the average acquisition price of your 1.68 million gallons of heating oil is $1.75 per gallon and that today’s futures price for delivery during your heating season is $2.05. In the past, market conditions in your distribution area were such that you could sell your heating oil to your customers at a price 25 cents higher than the prevailing futures price. To help finance your inventory purchases, you borrowed money. During the heating season, you have to make an interest payment of $600,000. Calculate the pretax profit for your enterprise in the cases shown in the spreadsheet without a hedge in place and with a hedge in place.

Base Case: No Change in Heating Oil Price Heating Oil Price Decrease Heating Oil Price Increase Heating oil inventory (gal.) 16,800,000 16,800,000 16,800,000 Selling price, per gallon $2.30 $1.90 $2.70 Avg. purchase price, per gallon $1.75 $1.75 $1.75 Futures price $2.05 $1.65 $2.45 Without a Hedge Revenue Cost of inventory sold Interest expense Pretax profit Pretax profit, per gallon With Short Hedge (short futures at $2.05)
Contracts needed Revenue Cost of inventory sold Interest expense Futures gain (loss)
Pretax profit Pretax profit, per gallon Futures gain (loss), per gallon