Question

11.1   In the northeast regions of the United States and in eastern Canada, many people heat their houses with heating oil. Imagine you are one of them, and you are expecting a cold winter, so you are planning your heating oil requirements for the season. The current price is $2.25 per U.S. gallon, but in six months, when you’ll need the oil, the price could be $3.00, or it could be $1.50 (if you’re wrong about the weather). (10 marks)

a.     If you need 350 gallons to survive the winter, how much difference would the potential price variance make to your heating bills?

b.    If your friend Tom runs a heating oil business that sells 100,000 gallons over the winter season, how would the price variance affect Tom?

c.     What non-contracting strategy could you use to reduce the risk that you face as a purchaser?

d.    Could you make an agreement with Tom to mitigate your risk? Briefly explain.

e.     Assuming both you and Tom are risk-averse, does such an agreement make you both better off?

Answer 1