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 Daewoo 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.

It honestly depends on how Daewoo’s current financial standing is. I would not shut down the mine, but I would definitely slow production down substanally. The reason why I wouldn’t want to shut down the mine completely and even though they are loosing money, in the long run this might be better than shutting down the mine. You want to still have some force, machines running so when oil prices goes back up you can be there to capitalize. You don’t want to have machines not moving that’s when they can start to need serious maintenance is when you abandon and it could cost alot more money to restart production after completely abandoning it. Also just because you are loosing money doesn’t mean you should necessarily stop, this seems temporary and any loss you run during this time period is just a tax write off for when the good years hit. Also oil prices are volatile they go up and down all the time, if you shut down production at what point do you go back into production? But no, personally I would keep the mine running and just ride the storm out as they would say. If the company is in good standing financially try and buy out a few weak competitors, it’ll make you a lot more money in the long run as you’re buying it on sale, consider it black friday.

No, Daewoo should not add capacity as doing so will only hurt it’s own profits as producing more will only lower the price of each additional barrel. Simple supply and demand, the more demand there is for something the more it’s value goes up. But if you start producing more so that you overwhelm the demand it’s price is only going to fall. In this case I would just try and to amass as much cash as you can so when there is a downturn you can be ready to buy out your weak competitors when it’s cheap.