Question

Analyzing an Oil Lease as an Option to Drill for Oil

Suppose you own the option to extract 1,000 barrels of oil from public land over the next two years. You are deciding whether to extract the oil immediately, allowing you to sell the oil for $20 per barrel, or to wait until next year to extract the oil and sell it then for an uncertain price. The extraction costs are $17 per barrel. The forward price is $20, and you know that oil prices next year will be either $15 per barrel or $25 per barrel, depending on demand conditions. Are you better off extracting the oil today or waiting one year? Explain how your answer might be different if prices next year are either more or less certain but have the same mean.

Answer 1

Let us do the calculation per barrel and use an option tree for the same.

Cost of extraction per barrel = $ 17

Now, if the price per barrel is higher than 17, then only extraction option will be excercised and Net Profit = Sale Price - Extraction Cost

If the price per barrel is lower than 17, then the option would not be excercised and Net Profit = 0

Now, let us look at the option tree given below:

Year = 0 Year = 1 Oil Price Net Profit 25.00 8.00 0.5 Oil Price Net Profit 20.00 3.00 0.5 Oil Price Net Profit 15.00 0.00

Year 0 = Option Excercised Immediately

Current Sales Price per barrel = $ 20

Extraction Cost per barrel = $ 17

Net Profit per barrel = $ 3

Year 1 = Option Excercised Next Year

Assuming, that there is equal probability of the price being at $25 & $15

Then, when price is $ 25, the Net Profit per barrel = $25 - $17 = $8

when price is $ 15, the option is out of the money and shall not be excercied. Hence, Net Profit = 0

Accordinly, the overall probability weighted net profit per barrel, if the extraction is done next year is:

Probability weighted Net Profit per barrel = 0.5 * $8 + 0.5* $0 = $4

Based on this analysis, (assuming no time value of money as no discount rate has been given), it is better to excercise the option next year and wait one year to extract the oil .

Part 2: How will the decision vary as the prices move but the mean is certain

The mean of previous prices was $20 (mean $15 & $25).

Let us assumed a different set of possible prices i.e. $16 & $24, the mean for which is same i.e. $20.

Even when the mean is same, the decision might change as shown in the option chart given below:

Year = 0 Year = 1 Oil Price Net Profit 23.00 6.00 0.5 Oil Price Net Profit 20.00 3.00 0.5 Oil Price Net Profit 17.00 0.00

Year 0 = Option Excercised Immediately

Current Sales Price per barrel = $ 20

Extraction Cost per barrel = $ 17

Net Profit per barrel = $ 3

Year 1 = Option Excercised Next Year

Assuming, that there is equal probability of the price being at $23 & $17

Then, when price is $ 23, the Net Profit per barrel = $25 - $17 = $6

when price is $ 17, the option is at the money and shall not be excercied. Hence, Net Profit = 0

Accordinly, the overall probability weighted net profit per barrel, if the extraction is done next year is:

Probability weighted Net Profit per barrel = 0.5 * $6 + 0.5* $0 = $3

Now, in this case, since the profit is same in both scenarios whether you extract oil immediately or next year. Its better to exercise the option immediately and extract the oil now. Hence, the decision will change to excercising the option immediately.