Question

A huge international oil company is considering its strategy in the Arctic Sea. The UK government has announced that a new drilling site in the Arctic Sea will be offered for sale on a competitive tender basis, the site going to the company making the highest bid. Temporary exploration of the site indicates that, over its life, it can be expected to generate revenue of around £1500 million if the oil reserves turn out to be high, but only £500 million if they turn out to be low. Seismic tests have indicated that the probability of high reserves is 0.60.

If the company is successful in its bid, it will also have to decide whether to construct a new oil rig for the site or to move an existing oil rig which is currently operating at an uneconomic site. The costs of the new rig are around £250 million and for moving the existing rig around £100 million. A new rig would be able to boost production by £150 million if reserve levels turned out to be high. The company has decided that if it is to bid for the site, the maximum bid it can afford at present, because of its cash flow situation, is £750 million. In the past, 70 per cent of the company’s bids for such sites have been successful.

However, the company is also under pressure to refurbish some of its existing rigs for both efficiency and safety reasons. The £750 million could be used for this purpose instead. If the money is used for refurbishment, there is a 50 per cent chance of increasing efficiency to generate a return on the £750 million of 5 per cent, and a 50 per cent chance of generating a return of 10 per cent. If the decision to refurbish takes place after the bid has been made and failed, only £500 million will be available.

(a) Construct a decision tree for this problem.

(b) Using the decision tree, suggest a suitable decision for management.

(c) Determine the value of perfect information about the size of the reserves on the new site.

Answer 1

Part a) Below is the decision tree:

The amount available for refurbishment at decision node F is $500 million while at node H is $750 million.

Part b) The EMV (expected monetary value) of making the bid is $186.25 million. Thus the management should make this bid.

Part c) Expected Value of Perfect Information,  EVPI = EVwPI – Maximum EMV

EVwPI = (best payoff for the first state of nature) x (probability of the first state of nature)+ (best payoff for the second state of nature)x (probability of the second state of nature)

EVwPI = 650*0.6 + (-350)*0.4 = $250 million

Thus, EVPI = 250 - 186.25 = $63.75 million.