Reference no: EM131016518

Xeno Petroleum currently has 3 million barrels of oil in reserves that will be extracted within the next three years at the rate of 1 million barrels of oil per year. Extraction costs are $20 per barrel and are expected to remain stable for the next three years (assume this rate includes all relevant variable costs and revenue related payments). The current price of oil is $100 per barrel. XenoAc€?cs exploration and development program has been on hold. The company anticipates that if oil prices gravitate above $100 that it will begin an exploration program at the end of the next three years that will cost $35 million. Xeno is constrained in capital markets and anticipates that it would fund a large portion of the $35 million from internally generated funds, in contrast to new borrowing or equity issuance. Forward contracts for the delivery of oil in one, two, and three years are available from a reputable bank at forward prices of $92, $89 and $88 per barrel respectively. Xeno has overhead costs of $3 million per year and interest obligations of $8 million per year (assume these values will remain the same over the next three years). The CEO and CFO (along with other senior executives and the Board) feel the company will suffer significant financial distress-related costs if it cannot meet these fixed obligations should oil prices fall. The company also wants to be in a position (in terms of cash reserves) to fund the $35 million exploration and development program if prices hit $101. What do you recommend Xeno should do regarding hedging price risk? (Ignore counterparty risk) (Hint: think about the two constraints and that the fraction of production hedged can range anywhere from 0 to 100%) What additional information would be useful to you in making the decision? How would you use this additional information? (Of course having perfect foresight about the future spot price would be great Ac€?o but that is not going to happen.)