A new marketing program:
In 1992, MGRM began implementing an aggresive marketing program in which it offered long term price guarantees on deliveries of gasoline, heating oil and diesel fuels for up to 5 or 10 years. Two contract alternatives are offered to customers
FIRM-FIXED: Customers are agreed to fixed monthly deliveries at fixed prices FIRM-FLEXIBLE: Fixed price and total volume of future deliveries but gave flexibility to set the delivery schedule. Customer could request 20% of its contracted volume for any 1 year within 45 days notice.
By 1993, MGRM committed to sell forward the equivalent of over 150 million barrels of oil for delivery at fixed prices with most of the contracts for terms of 10 years. Contracted delivery prices reflected a premium of $3 to $5 per barrel over the prevailing spot price of oil. Energy prices were relatively low by historical standards during this period and were continuing to fall. With this trend, MGRM stood to make a handsome profit from this marketing program. Nevertheless, a significant increase in prices could have exposed the firm to massive losses.
Options on the contracts:
Both contracts included options for early termination.
Cash-out provisions: Permits customers to call for cash settlement on the full volume of outstanding deliveries if market prices for oil rose above the contracted price. Customer would receive ½ the difference between the current nearby futures price (closest to expiration) and the contracted delivery price multiplied by the entire remaining quantity of the scheduled deliveries. (This option would be attractive for those customers in financial distress or simply no longer needed the oil) MGRM sometimes amended its contracts to terminate automatically if the front-month futures price rose above a specified ‘exit’ price.
Customer contract prices:
Contracted delivery prices...