Question

12. Luckoil Inc. owns a lease to extract crude oil from sea. It is considering the construction of a deep-sea oil rig at a cost of $70 million and is expected to remain constant. The extraction costs are $35/bbl. The quantity of oil Q = 300,000 bbl per year forever. The cost of capital is 6% per year (ignore taxes). Next year when the rig is constructed the price is expected to be either $60/bbl or $30/bbl with 60% and 40% probability, respectively. The firm can cap the rig at a cost of $10 million (abandonment option). The firm can restart pumping when oil price more favorable. Calculate the value of the abandonment option. Please show work

Answer 1

Solution:

Worst-case scenario: Price of petrol = $30 per bbl

Probability of worst-case scenario = 50%

Extraction cost = $35 per bbl

Cost of capital (r) = 6%

Quantity sold = 300,000 bbl per year forever

Total loss = -5*300,000 = -1,500,000

Since it is perpetual cash flows, thus, NPV of the project = CF1/r

CF1 = next year cash flow

NPV = -1500000/6% = -25,000,000

Firm can cap the rig at a cost of = - $10,000,000

Since the loss will be high (-25,000,000) in case of continuation while by rigging the loss in form of cost will be -$10,000,000

Hence, one should abandon the proect instead of continiuation

Cost saved at the end of 1 year = -10,000,000 - (-25,000,000) = +15,000,000

The probabilty of the event of fall in petrol price = 50%

Hence, present value of the abandonment option = Cost Saving*Probability/(1+r)

= 15,000,000*50%/(1+6%)

= 15,000,000*50%/1.06 = $7,075,471.69811 = $7.08 million