Consider Two drilling Site, A and B. First, consider site B alone. The estimated drilling cost...
Consider Two drilling Site, A and B. First, consider site B alone. The estimated drilling cost is $40 million. For simplicity, assume that if you drill at this site, there are two possible outcomes: either there is oil at the site or there is no oil. Based on the available data, your geologists assign a 20% chance that there is oil at the site (the site is "wet"). If there is oil, your geologists believe that the expected present value of a well in this location is $160 million (not including the drilling cost). If there is no oil (the site is "dry"), assume that the value of the drilled site is $0. a) Should you drill at site B?
b) Suppose you could find out definitively whether or not there was oil at this site, before deciding whether to drill. What is the most you would be willing to pay for this information?
c) Although you cannot resolve all the uncertainty about whether the site contains oil, you can gather some information. In particular, you can do seismic testing. In this procedure, one sets off explosives on the ocean floor and measures the seismic waves at other points on the ocean floor. From the seismic data, one can construct a 3D image of the subsurface geology and see if there are structures that may form an oil reservoir. Your geologists estimate that most (90%) of the wet sites have structures that can be detected by this seismic test. However many (60%) of the dry sites also have these structures. The seismic test costs $2.5 million. Do you want to do the test?
Now ignore the possibility of doing the seismic test and consider two sites. Like B, site C costs $40 million to drill and, if C is wet, the expected present value is $160 million; otherwise, the value of C is $0. Because of geological similarities between the two locations, the outcomes at the two sites are not probabilistically independent. In particular, if site B is wet, then the probability that C is also wet is 65%. If B is dry, then the probability that C is dry is 90%.
d) Should you drill one, both, or neither of these sites? What is the optimal drilling strategy
(Using a decision tree)
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