Question

A columnist for the Wall Street Journal discussed the fact that some firms were buying existing drilling operations in Canadian oil sands regions. These operations would not have been profitable to build from scratch but were profitable to operate given that they were already built because, as the columnist said, "The key is the distinction between fixed and variable costs. While the fixed investment in new oil sands projects is prohibitive, variable costs can be in the low \(\$ 20\) range per barrel." The columnist estimated that the fixed cost of a new oil sands drilling operation could be \(\$ 95\) per barrel. At the time the column was written, the price of oil was about \(\$ 50\) per barrel. a. Assuming that variable cost of an existing oil sands operation is \(\$ 20\) per barrel and the price of oil is \(\$ 50\) per barrel, how much were the companies selling these drilling operations losing per barrel? b. At a price of \(\$ 50\) per barrel, were the companies buying the existing drilling operations earning a profit of \(\$ 30\) per barrel? If not, explain what information we would need to calculate their profit.

Short answer

(a) The companies selling the drilling operations are not losing but are making a profit of $30 per barrel. (b) The companies buying the operations are also making an earning of $30 per barrel, but without knowledge of their fixed costs, one cannot confirm if this is a profit or loss.

Step-by-step solution

Determine Variable and Fixed Costs per Barrel - Part a

For the companies selling the drilling operations, the variable cost per barrel is given as $20. The fixed cost per barrel would not be relevant to these companies as they are already sunk costs.

Calculation of Loss per Barrel - Part a

Given that the selling price per barrel is $50 and the variable cost per barrel is $20, subtract the variable cost from the price to calculate the amount the selling companies are earning or losing per barrel. The calculation is $50 - $20 = $30. The selling companies are not losing but rather making a $30 per barrel.

Determine Costs and Revenue per Barrel - Part b

For the companies buying the existing operations, the variable cost per barrel is $20. Without additional information, we're not sure about the fixed costs per barrel these companies have to pay. The revenue per barrel they receive is $50.

Calculation of Profit per Barrel - Part b

Without the fixed cost, the calculation for determining profit per barrel would be the same as for loss. Here, a $30 earning per barrel ($50 - $20) can be calculated. However, this does not consider any fixed costs per barrel. For actual profit, we would need to subtract any fixed costs from this $30.

Key concepts

Oil Sands Operations

Oil sands operations involve the extraction and processing of heavy crude oil found in specific sand deposits, predominantly in regions like Canada. These operations require substantial infrastructure, machinery, and technology investments to not only extract but also refine oil sands into usable products. The start-up costs encompass both fixed and variable elements, with fixed costs covering infrastructure and equipment that do not change regardless of production levels.

• Fixed Costs: These include costs for building the facilities and acquiring the necessary technology for extraction and processing. These are initial outlays and hence do not fluctuate.
• Variable Costs: These are costs that vary with production levels such as utilities, labor, and maintenance that grow as more oil is extracted and processed.

When companies view existing operations as acquisitions, the prohibition of constructing new ones underscores the costly nature of infrastructure investment and favors operational investments where fixed costs have been absorbed by previous owners.

Profit Calculation

To calculate profit, one must look beyond mere revenues and variable costs and include fixed costs into the equation. The basic formula for profit is:\[\text{Profit} = \text{Revenue} - (\text{Fixed Costs} + \text{Variable Costs})\]When a company finds oil sands operations profitable, it means their revenues exceed these aggregated costs. In the case presented, with a variable cost of \(\\(20\) per barrel and oil prices at \(\\)50\) per barrel:

• Revenue = Price per Barrel = \(\\(50\)
• Profit per Barrel Considered Without Fixed Cost = \(\\)50 - \\(20 = \\)30\)

Yet, fixed costs can alter this landscape entirely. Without understanding the specific fixed costs for each acquiring company, we cannot finalize the profit calculation.

Cost Analysis

Cost analysis in oil sands operations involves a detailed examination of both fixed and variable costs to understand the economic viability of operations. A firm must acknowledge the relationship between these costs and the overall revenue potential.

• Fixed Costs in building new structures are considered excess and prohibitive in oil sands operations.
• Variable Costs, exemplified in labor and operational expenses, fluctuate with production levels; these are relatively low in established operations at \(\$20\) per barrel.

The analysis focuses on maximizing profitability by optimizing operations primarily through controlling variable costs, as fixed costs are often significant but immutable once incurred. To decide on acquiring operations, understanding the cost structure is core in ensuring revenue outweighs total costs, making the endeavor profitable.

Sunk Costs

Sunk costs are a crucial financial concept, particularly relevant in scenarios like oil sands operations. These are expenses that have already been incurred and cannot be recovered, such as the initial capital investment in infrastructure and setup. They should not factor into decision-making regarding production or continuation of operations.
In the scenario discussed, the buyer of existing operations disregards fixed costs because these were originally borne by the sellers and are thus considered sunk. This approach allows the buyer to focus solely on variable costs in operations:

• Sellers cannot recover the fixed costs, they are sunk.
• Buyers focus on operational profitability, mainly deducting variable costs from revenue.

Understanding sunk costs helps avoid fallacies in business decisions. Companies need to focus on future operational costs and revenues without worrying about past expenditures.