Production Functions and Cost Functions in Oil Pipelines Essay

1. For an 18-inch pipeline designed for 150,000 barrels per day, what is the short-run cost per barrel (per thousand miles) of transporting crude oil if the throughput is (a) 50,000 barrels per day (b) 100,000 barrels per day (c) 150,000 barrels per day? Using chart 7, a) Cost of transporting 50,000 barrels would be 30 cents. b) Cost of transporting 100,000 barrels would be 17 cents. c) Cost of transporting 150,000 barrels would 16 cents. 2. Can a 16-inch pipeline with 10,000 horsepower transport 100,000 barrels of crude oil per day? If a firm has a 20-inch pipeline, how much horsepower must be used to transport 150,000 barrels per day? This question can be approached in two ways. Both the approaches give different answers. a. Using Chart 1, a 16-inch pipeline with 10,000 horsepower will NOT be able to transport 100,000 barrels of crude oil per day. The pipeline will require at least 20,000 horsepower. If a firm has a 20-inch pipeline and wants to transport 150,000 barrels per day, they should use 20,000 horsepower. b. Using formula , T = (H) (D ) / (0.01046) When D= 16 inches H= 10,000, we get T= 349619.69 barrels. Thus, a 16 inch line pipeline with 10k horsepower can transport 100k barrels of oil. If the pipeline is 20 inch and we need to get 150k barrels of oil, using the formula, we will need 357.79 3. Does it appear that there should be many pipelines competing to transport crude oil over a particular route? Why or why not? I don’t think there would be multiple lines competing to transport crude oil over a particular route unless there is more demand than what is currently being supplied. It does not make economic sense to run pipelines at less than maximum capacity as they require a huge investment. The cost of laying the line and the materials costs of steel, pipe coating, line block valves, corrosion protection and so forth are a huge investment and would not be feasible for an oil company if the pipeline would not be supplying oil to its fullest capacity. 4. According to Leslie Cookenboo, plant D in Figure 1 â€Å"is not the optimum plant for the output at which it itself is most efficient (Q1).† How can this be? Explain. Optimum point is the point where the output costs the least per unit. The point where Q1 falls on the curve of plant E is lower than the lowest point on the curve of plant D. Therefore plant E can produce D’s optimum output more cheaply than D. 5. Leslie Cookenboo stresses the difficulties and limitations of estimating cost functions on the basis of historical cost data, rather than engineering data of the sort he uses. What are these limitations and difficulties? According to Leslie Cookenboo, where engineering estimation is feasible for cost studies it should be used, since actual costs may be subject to any number of erratic variations arising from construction or operating conditions unique to particular cases. In cases where engineering data is not available, historical data can be used, but using historical data makes the cost estimation prone to errors as it does not take into account the specific environmental factors that affect a particular situation. 6. Explain in commonsense terms why there are economies of scale in pipelines. In general, the average cost of transporting a barrel of oil decreases as total throughput increases. That is, oil pipelines are characterized by  economies of scale. There are several reasons for this: a) Setup Costs: The cost planning, design and installation are fixed setup costs. b) Volumetric Returns to Scale: Oil Pipelines are characterized by volumetric returns to scale. This happens because the cost of steel depends on its surface area while the capacity of the pipeline depends on its volume. Also, the amount of horsepower required is determined by resistance to flow which is decreasing in the diameter of the pipe. In the case, the production function is estimated as: This production function is characterized by increasing returns to scale. Doubling line diameter and horsepower leads to more than a fourfold increase in output but only a doubling in costs. c) Long run fixed costs: The cost of the personnel that monitor the pipelines is a long-run fixed cost due to the fact that a minimum number of personnel is required to monitor the pipelines regardless of the throughput. d) For the same level of reliability, larger pipelines require relatively fewer pumps in reserve. 7. Leslie Cookenboo has been senior economics adviser in the corporate planning department of Exxon Corporation. In what ways might Exxon have made use of his findings? Leslie Cookenboo’s study has 3 major findings: a. Economies of scale characteristic of the operation of pipe lines require that oil must be carried conglomerated in as large quantities as is possible in large diameter lines. This gives the least transportation costs obtainable. Exxon can reduce its transportation costs by transporting oil in large quantities in large diameter lines. b. Pipelines should not be run at throughputs appreciably below capacity; otherwise higher costs per barrel will be incurred than need be. Exxon can avoid higher costs per barrel by operating the pipelines at maximum capacity. c. Capacity of a large line can be expanded appreciably without increasing average costs. Decreased average costs can be obtained with moderate expansions.