Question

Decision Tree Analysis of an Oil Lease:


The remit is in the PDF file:


Questions:


(i) Draw a decision tree representing the decision problem facing the investors.


(ii) Suppose that L = 15 million pounds. What is the optimal policy for the investors to follow? Carefully explain your answer.


(iii) For what values of L would the investors’ optimal choice be to purchase the lease? Carefully explain your reasoning.

Aside. If we suppose that all potential investors are risk neutral and have the same beliefs about the future price of oil, then your answer to part (iii) also provides an estimate of the maximum price that the resource owners can charge for the lease.


(iv) An adviser to the reserve owners observes that it would never make sense for investors to pay for a lease and then choose not to develop it. To what extent would you agree or disagree with this observation? Explain your answer.


(v) Suppose that before the lease is offered for sale, the future price of oil becomes more variable. In particular, suppose that the price of oil in period 1 may be lower than originally forecast, so that now VL < 30. Suppose, for simplicity, that VH, the net present value of the oil produced in period 1 when the oil price is high, and the probabilities that the oil price is either high or low in period 1 are not affected by the change in the variability of the oil price.


The reserve owners are concerned that they will have to reduce the price of the lease L due to the change in the variability of the oil price. How much, if at all, would you advise the resource owners to reduce the price L that they ask for the lease? Explain your reasoning.


How does your advice depend on the new value for VL? (Note that I have not provided a new value for VL but only asserted that the new value is less than 30.)

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Answer 1

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Answer 2

A consortium of financial specialists is thinking about regardless of whether to buy a rent to misuse the stores of oil at a specific site.

There are two periods, period 0 and period 1.

The financial specialists must choose whether to buy the rent in period 0 and, in the event that they buy the rent, regardless of whether to build up the rent in period 0, period 1, or not in any way.

In the event that the financial specialists buy the rent, at that point they should pay a value L to the hold proprietors in period 0.

In the event that the financial specialists choose not to buy the rent, at that point they neither addition nor lose anything, and get an all out result of 0.