Question

Jet Black is an international conglomerate with a petroleum division and is currently competing in an auction to win the right to drill for crude oil on a large piece of land in one year. The current market price of crude oil is $114 per barrel and the land is believed to contain 516,000 barrels of oil. If found, the oil would cost $109 million to extract. Treasury bills that mature in one year yield a continuously compounded interest rate of 6 percent and the standard deviation of the returns on the price of crude oil is 65 percent.

Use the Black-Scholes model to calculate the maximum bid that the company should be willing to make at the auction. (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89.)

Answer 1

Use the Black-Scholes model to calculate the maximum bid that the company should be willing to make at the auction:

The auction is to win the right to drill for crude oil. In option terms, this is similar to having a call option.

Maximum bid = Number of barrels * Bid price per barrel (as per Black-Scholes model)

Thus, maximum bid price = $5,317,222.54

Workings: