Question

Simon Lafleur is the founder and sole proprietor of Wetaskawin Wildcatters (WW). WW develops oil wells in unproven territory. Simon has poured his life savings into WW in the hope of finding a major well.

WW has purchased drilling rights on a number of tracts that have been spurned by the major oil companies. Simon has just received a report from his consulting geologist that one of these tracts looks modestly promising.

The geologist has stated that based on his experience there is a one in four chance of finding a small oil reservoir on the site. Drilling for oil will cost $100,000 and if oil is not found this entire investment will be lost. Since WW has little capital left, this loss could spell doom for the company.

If oil is found there it would likely be enough to generate revenues of $800,000. (Ignore time value of money considerations – assume that the $800,000 can be compared directly to the cost of drilling, so that a net gain of $700,000 would be realized if he found oil.) Simon is confident that this amount of money would give him the breathing space required to find the really big “gusher”.

Shortly after receiving the report from the geologist, Simon was offered $90,000 for the drilling and extraction rights from one of the major oil companies. This would provide a good infusion of cash without the risk of losing $100,000 if he decides to drill.

1. Use a decision tree to model Simon’s decision (Tree plan is optional). Assuming that Simon bases his decisions on expected monetary value (EMV), what should he do?

2. Referring back to the model you created in part a), what is the expected value of perfect information (assume only Simon would have the perfect information, not the oil company)?

REMINDER: Expected Value of Perfect Information (EVPI) = Expected Value with Perfect Information – Expected Value without Perfect Information: EVPI = EVwPI – EvwoPI

3. In discussing the decision with the geologist, Simon has learned that a confidential seismic test could be conducted on the site at a cost of $30,000. The geologist estimates that, allowing for ‘false positives’, there is a 0.3 chance of getting a favourable test result in which case the probability of finding oil would be 0.5. On the other hand, an unfavourable result would indicate that the chance of finding oil is only 0.143. Use a decision tree to model this revised decision (again, can be hand drawn – TreePlan is optional). Assuming that Simon will base his decision on maximum EMV, should Simon conduct the test? Support your answer.

Answer 1