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.

When a recession hits, Daewoo should continue to produce oil even at a loss. Even if oil drops to a low as $50 and they lose $25 a barrel it would still be favorable to losing $35 a barrel on fixed costs. In addition to the plethora of inherent issues that come with stopping production such as loss of brand loyalty and contracts, stopping production would not solve the expenses of interest, depreciation, insurance, and administrative staff. Daewook should continue to produce at a loss for as long as they can as long as the price of oil stays above $35 a barrel.

Because of the high fixed costs associated within the industry I do not believe it would be a good idea for Daewoo to expand during a boom. An increase in production would inevitably lead to an increase in fixed costs that can not be easily reduced during a recession. However, in an industry such a oil that effects everyone a decision to not increase production will be meet by heavy backlash from the public. This is due to the overall increase in gas and other oil dependent commodities. While this public backlash can be devastating for the majority of industries, people have very little choice on who they purchase gas from or even how often.