Week 11: Real World Applications 10

Assume Daewoo, a hypothetical oil extraction company, has the following cost structure. It spends:

• $40/barrel on labor costs, raw materials, energy, and • $35/barrel on interest, depreciation, insurance, and administrative staff expense.

Read the textbook carefully, and answer the following questions.

• A recession hits, the market price of crude oil falls to $50 per barrel, and the profitability takes a hit. Should Daewook keep running the mine? Elaborate.
• Russia invades Ukraine, the market price shoots up well above $100 per barrel, and competitors announce new expansion plans. Should Daewoo add the new capacity? Elaborate.

The company Daewoo, is capital intensive since it is a oil extraction company which falls under capital intensive. If a recession were to hit, Daewoo would ultimately continue to produce oil even if the price drops significantly. Big companies like oil extractions, keep producing because if they stopped altogether, the company would face an even greater loss than just profit, but could potentially close down. The amount of time it take to add new capacity could be a couple of years and it might only add to profits for one year. During this period, it is better for Daewoo to accept the strong profit that they are bringing in and not add new capacity. Always think contrarian!