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.

A: I will stop running the mine, as it costs too much to run the mine and pay for the expenses, instead of completely stopping the selling of barrels, we can sell the barrels we haven’t sold yet, which will cover the cost of the excess expenses not including the running of the mine. All in all, this depends how much reserve oil we have initially during the down turn. The risk for continuing running is shutting down completely as we aren’t able to handle both finances within the mine and the other expenditures.

B: As a company the smartest decision is to expand with our competitors, instead of approaching countries in the ares they are going for, we should expand into new places, and continuing to please our current buyers. If we also find a way to lower prices lower than competitors while making a profit, we may be able to steal their current customers. If we also decide not to expand, we could make significant profit, as we will pay less for buying new things, but we risk that the competitor takes our customers because they provide more oil in the longterm.