Ajax Petroleum Chevron Went For SDU While Exxon Mobil

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Ajax Petroleum

Teaching Commentary

OVERVIEW

This short but very rich case is based on an actual capital expenditure decision in one of the major oil companies in

1980. There are three major themes in the case:

1. Sorting out the managerial insights in a “joint costing” product context.

ANSWERS TO ASSIGNMENT QUESTIONS

Question 1

The economic return calculations for the project under the various combinations of prices for resid and fuel

Question 2

This question should be easy for students if they focus on the incremental flows for the refinery as a whole.

Only the “opportunity cost” is relevant for the capital investment analysis. For both resid and fuel gas, this is the

current market price of resid, which is $25. This is the foregone revenue if resid is used as feedstock instead of

Question 3

Based on the information in the case, the project looks like a winner for the Middletown refinery on an

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Based on this uncertainty, some students will conclude that the project really hinges on the spread between

gasoline and resid prices rather than the absolute level for either one. It is then possible to calculate the break-even

spread to yield the desired 20% economic return. This is shown in the far-left column of Exhibit A. When the

Question 4

In fact, Mr. MacGregor did recommend the project and it was approved. It was built in 1981, within the

budgeted cost of $30 million. And it never made even one dollar of profit for Ajax! What happened?

At about the time of the case, gasoline demand peaked in the United States as a result of a lagged price

elasticity response to the steady run-up in prices between 1972 and 1981 (from about $.15/gallon to about

Was this result foreseeable? Did it catch all the major oil companies by surprise? In fact, Ajax was not the

only major oil company caught with an amazing total flop of an investment project. But many of the major oil

companies did not invest. The following table illustrates the split:

Yes No

Ajax (Gulf) $ 30 M Exxon

Since the incremental cash flows for the project should look the same to any oil company with a mix of heavy

oil (resid) and light oil (gasoline) sales, why did Exxon and Mobil walk away from such an apparently lucrative

Exxon

• Refineries geared to process heavy Venezuelan crude. A mix of outputs heavy in resid is expected and

planned for.

CONCLUSION: NOT REALLY INTERESTED IN GETTING RID OF RESID AT A HEAVY

INCREMENTAL CAPITAL COST.

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Gulf

• Refineries geared to process light Kuwait crude. But this supply was lost when their Kuwaiti reserves were

nationalized.

CONCLUSION: A PROJECT TO CONVERT RESID INTO GASOLINE LOOKS GREAT.

We don’t believe it is luck or contrarian judgment that explains why Gulf, Arco, and Chevron went for an

SDU while Exxon, Mobil, and Sohio/BP did not. Some finance/economics theoreticians who see capital

TEACHING STRATEGY

I use this case in a second-year MBA elective in Strategic Cost Management to review capital expenditure analysis

techniques while emphasizing a blending of calculations with strategic assessment. The case can also be used at or

near the end of a segment on capital expenditure analysis in an MBA core course.

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Exhibit A

AJAX PETROLEUM

Cash Flows Analysis for the SDU Project

B/E Spread

For The

Incremental

Cash Flows*

X – 1.1y Value of Cracking

= $3.70 Stock Produced $37.50 $37.50 $37.50 $37.50 $37.50

3.3M Operating Costs/Yr. 3,300,000 3,300,000 3,300,000 3,300,000 4,800,000

9.0M Operating Cash Flow/Yr. 4,255,000 3,171,450 47,617,500 29,550,000 28,050,000

4.9M After Taxes (46%) 2,297,700 1,712,583 25,713,450 15,957,000 15,147,000

Return on Capital Employed 19.8%*** 16% 176% 111% 36.5%

*With X = Value of Cracking Stock & y = Value of Resid. For example, if X = $37.50, then the break even value for resid to

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Exhibit B

AJAX PETROLEUM

A Joint Costing Example

• Assume 100,000 bbl. of crude are processed daily in the refinery at an average purchase price of $29 per barrel

(total cost – 2,900,000).

The question is how to apportion the $3,068,000 to the 95,000 bbl.

I. Volumetric Basis (Gulf)—Simply charge each bbl. for a proportionate share of cost ($3,068,000 ÷ 95,000 =

II. Market Value Basis (Exxon)—Assume gasoline feedstock costs $2.50/bbl. to convert to gasoline, which sells

for $39/bbl. Assume M/D costs $.60/bbl. to convert to fuel oils (jet fuel, diesel fuel, heating oil), which sell for

The overall cost ratio is 93% ($3,068,000/$3,309,000). Charging cost so that each product earns the same

overall gross margin (7%) yields the following figures:

III. Heat Value Basis (DOE)—It is a fact that the heavier the concentration of carbon in the oil, the greater its heat

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Relative Total Relative

Volume Heat Value Heat Value

Gasoline 45,000 90% 40,500 (44%)

Share of

Operating Costs Per bbl.

Gasoline $1,350,000 (44%) $30.00

These three approaches serve to illustrate the three general possibilities over the three product categories, equal

cost, increasing cost, or decreasing cost.

Gulf Exxon DOE

Volumetrics Market Values Heat Value (BTUs)

Exhibit C

AJAX PETROLEUM

Final Observations

1. “Herd mentality” is hard to fight, but you have to try.

2. What the “economic analysis” missed was future trend in gasoline consumption. How could we know?