MSC3100 (previously DSc3120)

Decision Analysis Project - To Drill or Not to Drill?

(revised 2-23-04)

TO Drill OR NOT TO Drill

Terri Underhill has recently been assigned to the economic analysis section of Global Oil. Prescot Oil
has just offered to buy the Burns Flat lease from Global for $15,000 and Terri has been assigned the
task of preparing Global’s response. The Burns Flat lease gives Global the right to explore for oil under
320 acres of land in western Oklahoma. Terri must recommend either to sell the lease or to drill.

If Global drills, the results are uncertain. On the basis of drilling records in western Oklahoma and
current market prices, Terri prepares a table showing the possible outcomes, the probability of each
outcome, and the net return to Global (Table 1).

Terri, however, knows that she does not have to make the decision simply on the basis of historical
records. DRI, Drilling Resource, Inc., will perform a test for $6,000 to determine the underground
formation of the Burns Flat terrain. The test will indicate which of three categories (plate, varied, or
ridge) best describes the underground structure. The conditional probabilities of the possible outcomes
vary with the underground structure. Table 2 shows the results of the last 50 tests.

If the test is taken, the opportunity to sell the lease is forfeited. The market for oil leases understands
that a decision to sell after the test has been performed indicates that drilling does not appear to be
profitable.

Instructions

Read the above case (also in your text at the end of the chapter on Decision Analysis - see page 456 in
the 6th Edition, or page 498 in the 5th Edition) entitled, “To Drill or Not to Drill”. However, follow
these instructions instead of the instructions in the text:

Create a joint probability table. Then calculate the posterior probabilities to put on the upper (test) part
of your decision tree. Make sure that you include this table in your paper! (3 points).

Create a decision tree, with all payoffs (net returns) and probabilities labeled. Solve the tree, labeling
all decision and event nodes with payoffs. [Note from the last paragraph in the case that the “sell
lease” option is only to be included in the bottom (do not test) part of the tree.] (3 points)

Answer these questions (1 point each):

1.a. What is the expected return for the optimal strategy prior to consideration of
testing (get from bottom of tree or from a decision matrix)?
b. Should global drill or sell the lease?

2.a. What is the optimal strategy when considering the possibility of testing?
(Make sure to explain what you would do based on every decision node on
 the tree!)
b. What is the expected return associated with the optimal strategy?
(This is the final solution to your tree - furthest left decision node.)

3.a. What is the EVPI? (Make sure to find the EVwPI first, and remember to
only use the bottom of the tree to do these calculations!)
b. Explain the meaning of the Expected Value of Perfect Information.

4.a. What is the EVSI? (This is the difference between the top and bottom of
the tree, excluding the cost of the test.)
b. Explain the meaning of the Expected Value of Sample Information.

TABLE 1

POSSIBLE OUTCOMES PROBABILITY NET RETURN

Dry Well 0.2 -100,000

Gas Well 0.4 40,000

Oil and Gas 0.3 90,000

Oil Well 0.1 200,000

TABLE 2

TEST RESULT/ PLATE VARIED RIDGE TOTAL

OUTCOME
Dry 8 2 0 10

Gas 2 16 2 20

Gas and Oil 0 14 1 15

Oil 0 0 5 5
10 32 8 50