The Impacts of Sunk Costs and Demand Destruction

11/27/08 – Thanksgiving Day

The collapse of oil prices to below $50/bbl coupled with the global financial crisis is yet another opportunity to look at what happens when investments are made in light of a price signal that may or may not be correct.

Sunk Costs
In my report Confessions of an Energy Price Forecaster I discussed the impact of the Trans Alaskan Pipeline System that was built in the 70s to move Prudhoe Bay oil to market. This whole complex was justified on a perception that oil prices were headed for $100/bbl, which in today’s dollars would have been more than double that estimate. In spite of the more than quadrupling of the cost of TAPS, once it was in place North Slope Alaskan oil became a relatively low cost producer.

While the investors certainly wanted to see the robust return on their investment that was projected by this high oil price scenario, the price collapse of the mid 80s was of little matter as long as the system’s operating costs were covered. This infrastructure capital cost was sunk. In spite of the reality of low oil price, Prudhoe production would not be backed out of the global supply mix.

The lesson here is that investments may be made based on faulty forecasts of price and therefore returns. However, once in place, the decision is one of covering the day-to-day operating costs of the project. (Note: Any conscious decision to try to curtail competition in a price war must look at operation not sunk capital costs.)

Demand Destruction
In a similar vein high product prices and the perception that such high prices may continue and even go higher can curtail the demand for that product. While such curtailment can shut in some existing production, that production can be brought back on stream later when demand conditions recover.

It is the investment in new productive capacity that is the issue that is comparative to sunk costs. If the investments are in the planning stages based on these high prices, seeing those high prices collapse and the high price scenario forecasts proven to be wrong can also “destroy” such plans.

This is where forecasts that recognize a range of possibilities proves its worth. The investment decisions must face both upsides and downsides in making an informed well-reasoned commitment. A simple break-even analysis and an assessment of the probability that such a break-even price will be reached, brings reality, transparency and the appropriate consideration of risk to the table. Indeed it is the decision maker’s fiduciary responsibility to follow such a path.

In the past OPEC has seen many such dramatic price swings. The reaction has been that prices low are hurting OPEC income. However, the silver lining to low prices are that competing source of energy are no longer economic and will not come into the supply chain (expect if the costs of that supply is already sunk.)

Points to Ponder 

  • Would the current financial crisis be as bad if such steps were followed in the mortgage and credit markets?
  • Would the irrational exuberance for some of the new forms of energy pass the reality test in light of such an analysis of price?
  • Where will energy demand go if the current recession is as deep and as long as the 80s recession that lasted 4 years, or, heaven forbid, the Great Depression?

Click here for more information about Confessions of an Energy Price Forecaster: A 12 Step Program to Enlightenment

Click here for John Tobin's full bio


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