Overview

Marathon Petroleum Corporation (NYSE: MPC), a U.S. based oil refining, marketing, and pipeline transport company, has a refining capacity in excess of 1 million barrels of oil per day. MPC needs crude oil every day and it may purchase it in one of two ways:

• Wait until a future date when MPC needs crude oil, and then buy crude oil in the spot market at the market price, or
• Enter into a long-term contract today for delivery of crude oil (forward contract) on a specified future date.

On 1/9/2012, the crude oil spot price is $98/bbl and the interest rate 6%.

Suppose MPC entered into a long-term contract (forward contract) on January 9, 2012 with Exxon to buy 1,000,000 barrels for delivery on September 1, 2012. The delivery price agreed for the contract is $100 a barrel. This means MPC will obtain 1,000,000 bbls on September 1, 2012 at a total cost of $100 million as agreed. What if the spot market price on 9/1/2012 is only $60 a barrel? Then MPC would have overpaid $40 million for the 9/1/2012 delivery compared to the spot price. What if the spot price is $120 a barrel instead? Then MPC would have paid $20 million less. (Of course, the supplier faces exactly the opposite situation.)

In other words, if MPC buys crude oil on the spot market, the cost of crude oil is uncertain, but the forward contract secures predictability of the cost of crude oil for MPC.

MPC, the buyer of the forward contract, is called to have a "long" position, and the supplier, the seller, a "short" position.

The main questions to think about in this lesson are:

1. How would you check if the forward price of $100 is arbitrage-free? [Hint: Devise an equivalent forward contract on 1/9/2012 using the crude oil spot market and the financial market for borrowing or lending. To simplify the analysis, assume the storage cost of crude oil is zero.]
2. How do you determine the value of MPC's long position for the September 1st delivery on any date before September 1st, 2012?

• on Jan 9, 2012? [Hint: value > 0. Why and how much?]
• on September 1, 2012 when the spot price is $120? [Hint: $20m. Why?]
• on March 1, 2012 when the spot price is $90? [Hint: value < 0. Why and how much?]

Learning objectives:

After completing this lesson, you will be able to:

• understand the concept and payoff profiles of a forward contract;
• price a forward contract on an asset with and without known amount of income;
• price a forward contract on an asset with known yield, not the amount;
• value an existing forward position on an asset with and without known amount of income; and
• value an existing forward position on an asset with known yield, not the amount.