18.12.14

RUNNING COSTS ARE AVOIDABLE, SUNK COSTS ARE SUNK, SOMETIMES WAITING HAS VALUE.

We began the week with a look at the effect of oil price movements on the marginal suppliers of crude oil, and of bio-fuel substitutes.  These don't all go away when the price of crude falls.  Here's John Palmer with the economics primer.  "But for the short run, very little if any of the existing wells will be shut down."  There's the traditional shutdown analysis, which causes introductory students no end of trouble, and which midwived the discipline of "managerial accounting" so as to end the fetish of fully allocated costs and the recovery thereof.  Sometimes you have to do something to lose less money.
So long as the oil companies are receiving enough to cover these marginal costs, they will keep pumping the oil. And that will occur so long as the spot price of oil exceeds about $40/bbl.  Pumping oil at those prices will cover the variable costs of pumping and make some contribution toward covering some of the overhead/fixed/sunk costs.
Then comes a harder proposition, one that a lot of novice students understand on a gut level, but which the discipline couldn't handle without Ito calculus, value-matching, and smooth pasting.
There is an exception not addressed in the article, however. If the costs of stopping and starting the pumping process are low, some oil companies may choose to stop pumping if they expect oil prices to rise in the future.

In this case, the marginal cost of pumping oil now is not just the extraction, transportation, and marketing cost; it is also the present value of lost higher revenues in the future, which of course depend on the expectations people in each oil company have about future prices for oil. If they expect prices to rebound in the near future, they may want to curtail some pumping; if they expect prices to remain low for the foreseeable future, they may decide to keep pumping.

Note, though, that this decision depends only on their expectations about future prices of oil and has very little to do with the marginal costs of pumping. Or, to put it differently, the marginal opportunity costs of selling oil for cheap now are the possible foregone revenues from waiting.
Or, to get wonkier, when you sell a barrel of oil today, you have killed the option of holding the oil and selling it for a higher price tomorrow. I have to go back to my notes on absorbing barriers to work out whether that option value is greater when the current price of oil is lower, or if that current low price drives that value of holding the option to zero.  Then all that matters is covering the running costs.

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