Question

Mobile Oil Company

The Mobile Oil company owns land in Alaska that might contain natural oil. The current value of the land is worth $90,000. However, if natural oil is present at the site, the oil will be worth $800,000. If the company decides to extract the oil from the land, the company will have to pay $100,000 in drilling costs.

Before drilling, the company has an option to carry out a seismic survey at the proposed drilling site. If they do not choose to carry out the survey, the company believes that there is a 0.25 probability that the proposed drilling site actually contains natural oil. However, if the company chooses to carry out the survey, the company will have to pay $30,000 for the test to be completed.

If the seismic survey is conducted, there are two possible outcomes. In other words, the survey will show either favorable or unfavorable result that natural oil is present. Based on historic records, if the results are favorable, the probability of hitting oil increases to 0.50. Even if the survey is unfavorable, there is still a chance that natural oil is present. However, if this is the case, the probability of hitting oil reduces to 0.14285.

If Mobile Oil decides not to drill, the company will sell their land at its current value. However, the land is considered worthless if the land is drilled. In addition, if the land has value (i.e. not drilled on), assume that the current value of the land does not change based on the results of the survey.

A summary of the financial parameters is shown below in Table 1, where costs are in terms of thousands of dollars.

Table 1: Financial parameters ($000)

Survey cost

-$30

Drilling cost

-$100

Current value

$90

Oil value

$800

Land value if drilled

$0

1. Develop a decision tree for this problem so that the expected monetary value can be evaluated.

a. HINT: Be sure to reference the tables that have been provided.

b. HINT: You will use the probabilities listed in Table 2 only once in order to develop a decision tree for this problem correctly.

2. Develop a formula that determines the highest expected monetary value that Mobil Oil can anticipate. In addition, develop a formula that will determine the course of action that Mobil Oil will take (i.e. Survey Do not Survey).

Please list out the excel formula's for each. I was not able to include the table for the data when I copied over.

Comments and Hints

Several probabilities are needed in order to construct a decision tree correctly. These probabilities are listed below in Table 2. However, to understand the probabilities that are given to you, please consider the following notation. For example, P(OP) is the probability of oil being present and P(OP|F) is the

probability of oil being present given (i.e. “|” ) that a favorable survey result was obtained. A

description of the abbreviations used in this problem is shown in the list below.

• OP Oil is Present

• ONP Oil is Not Present

• F Favorable Survey

• U Unfavorable Survey

The probabilities that are necessary to fill out the decision tree correctly are shown in the table below.

Table 2: Decision Tree Probabilities

P(OP) 0.25000%

P(ONP) 0.75000%

P(FS) 0.30000%

P(US) 0.70000%

P(OP|FS) 0.50000%

P(OP|US) 0.14285%

P(ONP|FS) 0.50000%

P(ONP|US) 0.85715%

Answer 1

consider the expected cash flow of the of the three options as below

	Property is not sold and survey isnot done	Property is not sold and survey is done	Property is sold
				Inflow	800000	800000	90000
Cost of exploration	-100000	-100000
survey		-30000
Total Inflow	700000	670000	90000

The Expected valus from the options are provided below:

Options	Cash Flow	Probability of cash flow	Expected Value	Total Value
Property is sold	90000	1	90,000	90,000
Property is not sold and survey is done	670000	0.15	1,00,500	1,67,497
	670000	0.099995	66,997
Property is not sold and survey isnot done	700000	0.25	1,75,000	1,75,000

Hence option of not selling the property is survey is not done is the better option.