Homework 5 Answers

Question 1 the global oil market is rather deep, liquid and that crude oil itself is fungible. This means, stripped of the technicalities, that one barrel of oil is much like another one. This isn’t entirely true: Canadian tar sands oil, Venezuelan stuff, they are both much heavier than most others and need specific refineries to treat them. But that light Arabian oil really is fungible. Refineries around the world can make use of it at least to some extent (indeed, some use it to blend with those heavier ones to make refining easier).

Question 1 (continued) what this fungibility means is that it just doesn’t matter a darn whether the US, or US companies, buy or not Saudi oil. Total oil demand around the world will be the same, total oil production around the world will be the same. All that will change will be who buys what bit of oil. So, for example, the US might buy more West African oil. But that West African oil, before it was routed to the US, might have been going to Europe. So, the US buys more West African instead of Saudi, Saudi now sells more to Europe and West Africa less. (Source: Forbes March 27, 2016)

Question 1 (cont.) Not fungible? There are different grades of oil Sweet, sour Light, heavy The U.S. prefers sweet, light oil for refining into gasoline.

Question 2 P < min AVC. Ordinarily, a profit-maximizing firm would not do this, as P = min AVC is shut-down point in the SR. But John D. Rockefeller had “deep pockets.” Only works if there is a long run barrier to entry. If John D. later charges monopoly P Will attract new entrants John D. will not be able to recoup SR losses.

Question 3 Percentage of total energy use accounted for by oil. 35% Percentage of oil used for transportation 70% Percentage of carbon dioxide emissions due to transportation 25%

Question 4 Upstream: Production stage Oil exploration, extraction Midstream: Between production and end use Pipeline transport; possibly refining, storage Downstream: Delivery to customer Bulk storage, gas station

Question 5 Cartel model Strength(s) Weakness Describes quota process Restrict output to raise price Weakness Doesn’t get at outsized role of Saudi Arabia Swing producer

Question 6 Apply monopoly model to get P and Q Competition: P = MC P = 100-0.5Q MR = 100-Q MR = MC 100-Q = 20 Q = 80 Each country received 80/10 = 8 P = 100 – 5(8) = $60 Competition: P = MC 100-0.5Q = 20 Q = 160, P = $20

Question 6 (continued) $ $100 DWL = 0.5($60-$20)*(160-80) DWL = $1600 MC MR D Q 80 100 160 200

Question 7 SR: Individual members have incentive to produce more than their quota. From individual member perspective, increase output to where P = MC. LR: Have to prevent entry to maintain high price. Difficult if producers outside OPEC will not join organization.

Question 8 Strength: Weakness: Saudi Arabia dominates OPEC decisions. Other firms don’t simply follow. Iran wants to increase production Venezuela wants to reduce output Restore P = $100/bl.

Question 9 Swing producer: When P < target P, decrease production. When P > target P, increase production. Stopped acting as swing producer in 2015 P < target P, but increased production

Question 10 External costs of oil other than emissions National security costs of defending oil supplies Traffic congestion from automobiles Oil spills

Question 11 A difference between forward and futures contracts is: Forward contracts are traded on an exchange, whereas futures contracts are traded over-the-counter. Forward contracts publish their prices, whereas futures contracts are not required to disclose their price. Both a. and b. are correct. Neither a. nor b. is correct.

Question 12 Buy a put right to sell oil at today’s price Make money if future price is lower than today’s price Which is what you expect will happen if OPEC does not stick to its plan to cut oil production.

Question 13 You expect the price of jet fuel to rise if OPEC cuts production. To offset the price increase in jet fuel A hedger needs a contract that will produce a profit if the price of fuel oil increases. Buy call option. If price of fuel oil increases, option will increase in value. The increase in the value of the fuel oil option will offset the increase in the price of jet fuel.

Question 14 Contract costs $50,000. You pay $10,000. One month later, contract worth $55,000 Sell for $5000 profit 50% return on $10,000 investment.