Question

SBT Petroleum Inc. owns a lease to extract oil from an oil field in Texas. An initial construction cost of $50 million is required and this cost is constant no matter when the construction starts. Suppose the crude oil price is uncertain and can be $50/barrel or $30/barrel with equal probability next year. Further assume that once the price is confirmed at t=1, it will remain constant forever in future. The extraction costs are $25/barrel constantly. The quantity of crude oil Q = 300,000 barrels per year forever. The risk-free interest rate is 6% per year and that is also the cost of capital (ignore taxes). Assume revenue is earned and costs are paid at the end of each year. Using real option analysis, determine whether it’s optimal for the firm to invest now or in one year.

Answer 1

Initial Construction Cost is a sunk cost which is $50 million. That amount will not be recovered and it has to be incurred whether at t=0 ot t=1.

As the crude price is uncertain. It can go up to $50 or $30 with equal probability as of now until it gets fixes by t=1.

Let me calculate the NPV using real option analysis.

At t=1

Weighted average crude price= (0.5*50)+(0.5*30)=$40 per barrel

Cost of extraction= $25 per barrel

Quantity of crude oil is 3,00,000 barrels.

So profit per barrel is $15.

The total profit is $45,00,000

The Present value of the net profit is $ 42,45,283.02

Ignoring thesunk cost the project is giving a positive value. So the firm should invest now