A big story
this week is that Royal Dutch Shell will cease exploration in the arctic. Reportedly, they had invested in $7 billion in the effort but the prospects don't look so good now after disappointing results, a fall in the price of oil, and increased uncertainty over environmental regulations. The important lesson that Shell recognized is that a $7 billion sunk cost is still a sunk cost.
Aphrodite and Leviathan gas fields probably helped RDS decide to pull the plug. Why invest all that capital in rigs when they have a gusher worth 20 years of fuel in the Energy Triangle? Major bummer for Big Oil. -SCReplyDelete
This is all about the cost of oil and the potential return on investment. As the NY Times article below continues to point out, environmentalist groups are calling this a victory for them. It is understandable that they will want to capitalize on the moment, but at the end of the day, Shell was making a simple economic decision, not an environmental one. With oil prices declining, Shell must have done a break analysis over the long term to help make this decision. Apparently, large volumes must be achieved to move forward, and Shell did not feel that this was possible, even with the availability of oil in the region (so say the experts).ReplyDelete
This reminds me of a Freakonomics story where 1980’s politicians were trying to take credit for the decline in crime at that time with their investments in the police force. However, as Levitt and Dubner argue, the drop in crime was attributed to an entirely different reason – the legalization of abortion in 1973 and uses data to support their rationale.
Anyways – politicians will never pass up an opportunity to take credit, right?
From the New York Times Magazine of December 30, 2014, the main cover story was devoted to Royal Dutch Shell’s artic oil rig explorer, “The Wreck of the Kulluk.” As mentioned in the article, in 2005 the “break even” price for oil in unconventional projects was $70/ barrel. Shell determined around that time that the artic oil reserves potentially available would be profitable if found and were able to be accessed. Unfortunately, very poor timing and extremely inhospitable weather conditions eventually turned the Kulluk expedition into a disaster.ReplyDelete
Shell was unaccustomed to give up. Despite severe financial loss from the Kulluk misadventure and tremendous opposition from environmental groups, the company (assume the “C” suite members) voted to press on to develop the prospective gigantic oil reserves if located. To mention, the weather and rough seas conditions off Alaska for the prolong winter months make for extremely hazardous conditions to both search for and actually produce the oil. With the current price of oil (both WTI and Brent) fluctuating in the $40s/barrel range, and the expectation of prolonged residence in this range before rising, would clearly have revenues falling far short of the costs of production, even if the oil was found. (Recalling that MR should be greater than MC for this prospective venture to be successful.)
The $7 billion sunk cost now has been capped, before further hemorrhage (leakage) would be sustained. [Much in remembrance the way the BP spill in the Gulf of Mexico should have been capped early and correctly before the great damage was unleashed. The Gulf is relatively mild compared to the Artic seas off Alaska in the winter. Imagine a similar disaster on the Shell rig, would be many times worse. The fines and cleanup would bankrupt Royal Dutch Shell.]
reference: The New York Times Magazine, "The Wreck of the Kulluk," 12/20/2014
“The important lesson that Shell recognized is that a $7 billion sunk cost is still a sunk cost.”ReplyDelete
This is a very important lesson that unfortunately many organizations fail to realize until it is sometimes too late. The thinking today seems to be that because we invested this money, we should see it through to completion. There comes a point when you are just throwing good money after bad. The key for a company or investor is to avoid the “sunk-cost fallacy, where decisions are made using irrelevant costs and benefits” (Froeb, McCann, Shor, & Ward, p. 33). Decisions to stay or leave should not be made with sunk-costs in mind. It is apparent to this reader that Shell did not fall victim to this and decided that money spent was just that….money spent. Rather than continue to invest in an area where the payoff was uncertain, they closed up shop and are moving on. It was an expensive lesson for Shell, but one that many other companies should learn from.
Froeb, L., McCann, B., Shor, M., & Ward, M. (2014). Managerial Economics - A Problem Solving Approach (4th ed.). Boston: Cengage Learning.
Benefits, Cost, and Decisions.ReplyDelete
In, today’s fast pace economy, it is important for managers and executives to make profitable business decision, in order to sustain a competitive advantage within their industry. To complete this objective, management needs to recognize the relevant benefits and cost of a decision, and remember to consider the consequences of their decision from the organization’s viewpoint.
Consequently, there are numerous cost that must be considered, in order to make good solid business decisions. In other words, a benefit-cost analysis must be performed, to recognize a profitable decision. Some of the cost that must be considered in this type of analysis are the following:
• Opportunity cost- the opportunity cost of an alternative is the profit an individual gives up to pursue it.
• Relevant cost-are all cost that vary with the consequence of a decision.
• Fixed cost-are cost that do not vary with output.
• Variable cost-
• Fixed cost fallacy- is consideration of costs that do not vary with the consequences of your decision (also known as the sunk-cost fallacy).
• Sunk-cost-are cost that cannot be recovered. They are unavoidable even in the long run.
• Hidden cost fallacy- occurs when you ignore relevant costs, those costs that do vary with the consequences of an individual’s decision.
Authors, Froeb, McCann, Shor, and Ward, state “Don’t forget this simple maxim: If you begin with the cost, you will always get confused; but if you begin with the decision, you will never get confused (p. 35).” This is a great quote, and someone at Shell should have considered all of these factors.
Froeb, McCann, Shor, & Ward, &. (2014). Managerial Economics "A Problem Solving Approach". Boston, MA: Cengage Learning.
Risk analysis is very important, especially when such an enourmous investment is being made. You would think that Shell and its investors conducted an extremely through analysis, yet with mis-forecasts. The fact that the price of oil has decreased, as well as still some uncertainty in the Middle East, an almost calm period has taken over, thus changing the forecast of oil. Yes it is a huge decision to pull the research after such an ivestment, but knowing when to call it quits before the number rising is also a very good plan going forward.they may be able to fund other future projects now, some of which may yield to be fruitful.Delete
Shell pulls out of artic? From an environmentalist minded point of view that sounds good to me! From an economic point of view it sounds like it was best for Shell to cut their losses and move on.ReplyDelete
According to Shell’s 2014 Financial Statements available at the following web address: http://reports.shell.com/annual-report/2014/strategic-report/results/selected-financial-data.php?cat=b, Shells’ revenue for 2014 was $421,105, 000,000. $7 billion dollars is less than two percent of that. Therefore, $7 billion may immediately sound like a great deal of cost, once you consider the bigger picture/the size of shell, it is just a small cost of doing business. This $7 billion is a sunk cost. It’s unrecoverable. Management made the decision that dropping the project would add to the future value. The opportunity cost was too great.
It was interesting to hear that Shell had stopped exploring in the artic. For a company to have already spent over seven billion dollars, you would think that they would follow through. I think that this investment would be considered an opportunity cost, which is the “cost of an alternative in what you give up to pursue it” (Frroeb, McCann, Shor, & Ward, 2014, p. 32). In this Shell situation, Shell decided that if they were to cease their exploration, they would not continue to spend money on the situation. Shell had already spent so much money on this endeavor and did not receive any profit from it. The benefit of pulling out from this endeavor was that they would not continue to put money in. This endeavor was something that was going to be a risk and they knew that from the beginning. Seven billion dollars was not that much money considering the amount of money that the company is worth.ReplyDelete
Frroeb, L. M., McCann, B. T., Shor, M., & Ward, M. R. (2014). Managerial Economics" A Problem Solving Approach. Australia: Cenage Learning.
$7 billion dollars is a substantial investment on any level. When Shell announceed they were going to cease their exploration of the Artic for oil, it is hard to fathom why they would stop after investing so much into the project already. But the impact of the market price for oil has dropped the potential value of this exploration and the opportunity costs are now different than what they once were. What is interesting in their situation is whether or not it was the market's change in value of oil that was the tipping point of the decision. If this was the case, then Shell stayed focused on the opportunity costs and made their decision based solely on those opportunity costs, ignoring the sunk costs they had already invested.ReplyDelete
Froeb et al (2014). Managerial Economics: A Problem Solving Approach. Australia: Cenage Learning.