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.

Place your answer here.

Since oil companies are considered capital intensive, even though Daewoo is prone to large losses during a recession due to loss in profit, it is still considered worthwhile to run their mine. This is smart because basic economics would tell you that whenever market prices exceed that of variable costs, a capital intensive industry should run their business; in this case the mine. Since the market price is $10 more than Daewo’s variable cost, they would be making $10 to cover overhead. If Daewoo were to shut down the mine, they would make $0 in overhead, further hurting their business especially during recession. This can all change depending on supply and demand though. Since there are limited oil refineries, the ability to refine is limited where the United States alone uses more oil than it produces per day which can raise the cost of oil and that can spark investor fears, leading to halts in production. In this specific case, I would consider Daewoo smart if they continued production.

Given that Russia has helped cause a larger oil crisis than expected and the overall economy has been affected by these events, I believe that it might be smart for Daewoo to add new capacity right now. Russia has created even more global demand for oil as major players in the oil industry are cutting back on production of oil. There is global uncertainty across economic sectors and it is affecting investors and managers decisions especially with the oil industry. This could be a time for Daewoo to capitalize on their competitors’ decisions. Current oil companies decisions are being made to benefit the producers not the users which is affecting an already volatile situation. The oil industry needs to prioritize stability over pricing right now and Daewoo can help with that if they add new capacity. This is all dependent on economic standing though. Since the oil industry has historically long lead times, Daewoo should assess economic outlook before they make a decision on expansion, but if they are a company with strong morals, prioritizing stability will put them ahead of their competition.