Explain how MGRM's cash flows would have changed if the basis had increased (rather than fallen) and if oil prices had increased (rather than fallen)
What will be an ideal response?
If oil prices had increased, then MGRM would have closed out its monthly mountain of long futures contracts with gains and experienced considerable cash inflows. These gains would have been offset by the losses on the forward contracts, but the cash flow effects of the forward contracts would have been postponed until they matured. An increase in the basis would have improved MGRM's profitability because the company would have closed out its hedge in Year 1 at a spot price that was relatively higher than the futures price it would have to pay at the end of Year 2 . With a long hedge, any increase in basis increases the cash flows to the hedger. The combination of rising oil prices and backwardation was exactly the opposite of what MGRM experienced.
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