One of the more interesting business conundrums is; are prices set by costs or are costs reflective of prices? Clearly, there are no easy answers. Many business contracts are negotiated on a “cost/plus” basis, while others are based on a firm bid price for a specific product or service.
Investors should be aware of the cost/price relationship in reviewing the potential for specific business models.
For example, many observers did not believe that oil prices were likely to drop to $40/bbl., from more than $100, as drilling costs would quickly bring about sharp decreases in production and supply. Not so fast. It is becoming increasingly clear that as oil prices fall, drillers have found ways to reduce costs, essential to staying in business.
An interesting example, recently reported by Bloomberg Business, noted that Transocean has recently won a contract to drill four wells off Norway at a day rate of about $179,000. The punch line is, the rig in question is currently earning $373,000 a day on a contract running through March 2016.
Note to investors. Don’t underestimate the ability of markets to respond to changing conditions.
All comments and suggestions are welcome.
Walter J. Kirchberger, CFA®