Question 2: 10 points English Petroleum (EP) has to decide whether or not to dri

Question

Question 2: 10 points English Petroleum (EP) has to decide whether or not to drill for oil in a particular place. After its recent disaster in gulf, it has decided to conduct a thorough analysis before venturing into any new exploration projects. An in-house analysis revealed the following information: There are three possible results of drilling: a high yield with NPV $100 million, a moderate yield with NPV $50 million, or no oil. The drilling operation costs $50 million. At similar places, 50%, 30%, and 20% of previous drillings have given high, moderate, or no yield respectively. 1. Should EP drill for oil? What is the expected value associated with the decision. Now suppose a seismic test is available which would indicate a favorable, neutral, or discouraging prospects for the drilling. . There is a 52% chance the test will give favorable results; if it does, the respective probabilities . There is a 22% chance the test will give neutral results, if it does, the respective probabilities of . There is a 26% chance the test will give unfavorable results, if it does, the respective probabilities of High, Moderate, or No yield become 35/52, 15/52, and 2/52. High, Moderate, or No yield become 10/22, 6/22, and 6/22 of High, Moderate, or No yield become 5/26, 9/26, and 12/26. Answer the following questions based on the information above. Sreekumar R. Bhaskaran 2. Find the optimal decision on the assumption that a test is made. What is the maximum amount that would be worth paying for such a test?

Explanation / Answer

1) Expected Value of decision to drill = 0.5*100 + 0.3*50 + 0.2*0 - 50 = 15 ($m)

Expected Value of NPV of the decision to drill is $ 15 m, therefore, EP should drill for oil.

Expected Value associated with this decision is $ 15 m

2)

Expected Value of the decision to drill, if the test gives favorable results = (35/52)*100+(15/52)*50+(2/52)*0 - 50 = 31.73

Expected Value of the decision to drill, if the test gives neutral results = (10/22)*100+(6/22)*50+(6/22)*0 - 50 = 9.09

Expected Value of the decision to drill, if the test gives unfavorable results = (5/26)*100+(9/26)*50+(12/26)*0 - 50 = -13.46

Given that a test is made and if the test gives favorable results, Optimal decision is to Drill for oil

If the test gives neutral results, Optimal decision is to Drill for oil

If the test gives unfavorable results, Optimal decision is Not to Drill.

3) Expected Value with test = 0.52*31.73 + 0.22*9.09 + 0.26*0 = 18.5

Maximum amount worth paying for such a test = EV with test - EV without test = 18.5 - 15 = 3.5 ($m)

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