Your company has just received an IDIQ requirements contract from the United Sta

Question

Your company has just received an IDIQ requirements contract from the United States government to purchase a minimum of fifty million barrels of crude oil at $55 a barrel. The projected schedule calls for the delivery of 5 million barrels a month for the duration of the contract, two years plus three one-year unilateral government options. You received your first order for 5 million barrels today. You are currently producing 5 million barrels a day at your Texas properties and have plans to open additional wells over the next six months to increase output to 6-7 million barrels a day. The cost to deliver a barrel of oil today FOB Gulfport, Louisiana is about $35 a barrel.

Russia, OPEC, Iraq, and Iran just announced an agreement to manipulate the output of oil in order to increase its price above $60 a barrel. As such, the price of oil should increase, and the cost may increase as well.

Now the bad news, one of your offshore oil platforms off the coast of Mexico in international waters was attacked and captured by terrorists. Your oil workers were able to stop pumping oil and escape by helicopter. Tankers cannot dock or take oil for fear their ship will be taken by the terrorists. As a result, you are losing 2 million barrels a month and your contract with the government does not contain an escape clause that covers terrorists. What to do! To avoid a breach of contract situation you were able to find another source of crude oil to purchase at $55 a barrel, FOB Saudi Arabia for up to 3 million barrels a month and a maximum of 10 million barrels in total. You are also in contact with a company who, for $5 million dollars, will send in a team of Mexican drug cartel mercenaries to take back your oil platform. You expect it may take up to six months to regain control from the terrorists and return the platform to full operation.

Question:

How can you protect yourself from a rise in the price of crude oil; and

Determine your maximum and minimum loss exposure.

Explanation / Answer

Introduction:

This organization is already producing 5 million barrels a day at their Texas properties so meeting the contract requirements of United States Government (delivering 5 million barrels a month) shouldn’t be a challenge. Please note that the details about other contracts or average orders per month that the company is obliged to complete are missing in the question. Also, the details about the current financial condition (revenue etc.) of the company are missing.

From the details given in the question, to limit the risk and better prepared for future, the company can think of following:

1. Pay the company ($5 million dollars) who will send in a team of Mexican drug cartel mercenaries to take back your oil platform off the coast of Mexico and work with them to regain control from the terrorists. So that the platform will become fully operational in coming 6 months.

2. Till the time company's platform off the coast of Mexico becomes fully operational again, purchase the crude oil from the another identified source (FOB Saudi Arabia) to cover up for the 2 million barrels a month that could not be produced. Take 2 million barrels a month for 5 months from this identified source. This option should be exercised only if the company feels that it will not be able to meet the requirements of the current contract. As per the information available in question (Texas properties itself produces 5 million barrels a day), it seems there should be no challenge in fulfilling United States Government contract.

3. Continue investing in plans to open additional wells over the next six months to increase output to 6-7 million barrels a day.

How can you protect yourself against a change in the currency exchange rate against the USD:

By having a clause in the contract stating that if there are any changes in currency exchange rate against the USD (positive or negative), the purchase price of the deal will change proportionately.

How can you protect yourself from a rise in the price of crude oil and Determine your maximum and minimum loss exposure:

By continuing to invest in plans to open additional wells. By having own wells it will limit the dependency of purchasing/importing from external sources.

If needed to purchase crude oil from external sources, the company should identify nearest sources and develop a strategic long-term business relationship with them. By identifying the nearest source, the cost of transportation/delivery will be reduced and by forming a strategic long-term business relation, crude oil prices can be bargained.

To determine maximum and minimum loss exposure - financial details of the company (revenue, incurred costs, average orders per month etc.) are missing in the question.

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