Question: Question 2

In mid-February, 2008, Bill Snyder, CEO of Petro Enterprises, was analyzing whether his company should drill on a lease in Western Alberta. Petro had purchased a non-transferable option to drill on the lease for $10,000, which was due to expire on 28 February if drilling had not started by then. This was the only deal that Petro had on its current agenda.

Petro was founded 5 years before, in 2003, as a wildcat exploration company. After an initial two good years, Snyder had bought out his silent partners who had put up the initial funding for the company. In 2006 and 2007, however, Petro had drilled a number of dry holes and its asset position was reduced to about $300,000. However, Snyder did feel that the current site, situated as it was on the fringe of a producing field, was a reasonable risk. He commented, "Even though the option to drill cost $10,000, it is worth it because of the location. In the past two years we adopted a more risky strategy, looking at areas which had not been explored before. This search for a whole new field reduced our resources substantially. Drilling on this new site represents a return to our earlier strategy of extending an existing field rather than finding a new one. The potential payoff won't be as high, but the risk is also lower."

Petro had retained a geologist who examined the surface geology around the site. The geologist assessed a probability of 0.5 that a substantial oil find would be made if the site were drilled. Snyder concurred in this assessment, but also knew that a seismic test could be carried out for $40,000, which would provide more evidence about the possibility of oil. In particular, he felt that a positive result would increase the chance of a commercial strike to .8. However, even if the seismic results were negative, there was still a 0.05 chance of a commercial strike. Based on his own experience with seismic results and his knowledge of the lease property, Snyder believed that there was a 0.6 chance of a positive seismic test result.

It would cost $200,000 to drill the well. Snyder had already decided that, if oil were struck, Petro would not exploit the find itself but would sell the rights to a major oil company. Discussions with that company had already established an agreement that Petro would sell its rights for a flat $800,000.

Snyder has asked you to help him decide his best course of action with respect to the lease.

a) What is his best strategy, following an expected value criterion.

b) What is the expected value of perfect information? (That is, ignoring the seismic test for a moment, how much would Snyder pay a geological clairvoyant who could tell him with certainty whether there is oil on his lease or not?)

c) By how much does the expected value of the decision increase as a result of conducting the seismic test?

d) If you were Bill Snyder, would you have any reservations about the solution from part a)?