Oilco must determine whether or not to drill for oil in the South China Sea. If

Question

Oilco must determine whether or not to drill for oil in the South China Sea. If the decision is “not drilling”, the option can be sold for $10 million. If “drilling” is chosen, the well can occur to be dry with probability of 0.5 which would result in a loss of $70 million. The well may be wet with probability of 0.3 and a resultant payoff of $50 million, or may gush out with probability of 0.2 and a resultant payoff of $200 million. Assuming that Oilco is a risk-neutral decision maker, answer the following questions.

There is actually another option. Before making a decision about drilling, Oilco can hire a group of geologist at a cost of $1 million to obtain more information through a survey about the likelihood that the field contains oil. The survey might result as NO (no oil structure), OS (open structure), or CS (closed structure, oil more likely). On the basis of the track record of the geologists, we know that whenever the true state is dry, the survey indicates NO with probability of 0.6 and OS with probability of 0.3. Whenever the true state is wet, the survey indicates NO with probability of 0.3 and OS with probability of 0.4. Whenever the true state is field’s being a gusher, the survey indicates OS with probability of 0.4 and CS with probability of 0.5.

i. Determine EVSI and ENGSI.

Explanation / Answer

Expected value of not to drill = $ 10 million

Expected value of to drill = 0.5 * (- $ 70 million) + 0.3 * $ 50 million + 0.2 * $200 million = $20 million

If the geologist are hired.

Expected value of hire = 0.5 * Expected value for dry state + 0.3 * Expected value for wet state + 0.2 * Expected value for gush state

For dry state, the survey indicates NO with probability 0.6, OS with probability of 0.3 and CS with probability of 1-(0.6+0.3) = 0.1

Expected value for dry state = 0.6 * (- $ 70 million) + 0.3 * $ 50 million + 0.1 * $200 million = -$7 million

For wet state, the survey indicates NO with probability 0.3, OS with probability of 0.4 and CS with probability of 1-(0.4+0.3) = 0.3

Expected value for wet state = 0.3 * (- $ 70 million) + 0.4 * $ 50 million + 0.3 * $200 million = $59 million

For wet state, the survey indicates OS with probability 0.4, CS with probability of 0.5 and NO with probability of 1-(0.4+0.5) = 0.1

Expected value for gush state = 0.1 * (- $ 70 million) + 0.4 * $ 50 million + 0.5 * $200 million = $113 million

Expected value of hire = 0.5 * -$7 million + 0.3 * $59 million + 0.2 * $113 million

= $36.8 million

EVSI = Expected value of hire - max(Expected value of not to drill, Expected value of to drill)

= $36.8 million - max($10 million, $20 million)

= $36.8 million - $20 million = $16.8 million

ENGSI = EVSI - Cost of Information = $16.8 million - $1 million = $15.8 million

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