Question: The Norwegian Government has garneted Intech a lease to explore for oil and natural gas in the North Sea. Under the terms of the agreement, Initech must either proceed with production drilling in 6 month or must sell the lease to Exxon Mobil for $150,000. Intech’s crack financial team has calculated the returns of investment depending on the success of drilling efforts. If the well produces sweet light crude then Intech stands to profit $200,000 but if the well produces oil and gas the profit drops to $100,000. If the well only produces natural gas then the potential profit drops further to $50,000. Of course a dry well would be a disaster resulting in a net loss of $100,000.

The Geology office has conducted a detailed analysis based on core samples and a review of well in the same area and have concluded that the probability of a dry well is only 16%. For producing well in the Geology Office believe that the probability for an oil well, a gas well, and a combo well are 20%, 40%, and 24%. Furthermore, over the weekend the CFO issued the following guidance on current corporate risk practices:

Utility 0.0 0.04 0.16 0.33 0.55 1.0

Profit -$200k -$100k $0 $100k $200k $300k

a. Draw your preference curve. What type of risk profile exists?

b. Diagram the alternatives open to you.

c. Use the preference curve to determine your preferred course of action.

d. How would this course of action differ if you applied and EMV approach?