Betting the Business

Classes at MIT started yesterday, and this semester I’m teaching Corporate Risk Management again. The dramatic plummet in the price of oil over the last few months provides an outstanding live case study of all of the critical issues. To really get a flavor for what a major event this is, it’s useful to look back at the price over a long window of time.

Oil companies are facing a sharp cut in operating cash flows. How should they react? Should investments be cutback?

One factor in making the decision is the forecast of prices going forward. Are prices at a temporary low, from which they will bounce back? If so, cutting back investment may be unwise, sacrificing future profits.

Some companies may not have the luxury of deciding whether or not to cut investments. There may just not be enough cash. Of course, that’s where hedging could have helped, providing a cushion of cash flow to support ongoing investments through a tough patch like this. Companies have an amazingly diverse approach to hedging, and we can examine how different companies fare through these times.

Of course while a price drop is bad for producers, it is good for consumers. Airlines have been posting record profits, helped in part by the drop in jet fuel prices. Fares have not dropped in line with fuel costs, so the fuel cost savings have dropped to the bottom line.