Question

OP23-5: Real Options and is currently competing in an auction to win the right to drill for crude oil on a large piece of land in one year. The current market price of crude oil is $58 per barrel, and the land is believed to contain 375,000 barrels of oil. If found, the oil would cost $35 million to extract. Treasury bills that mature in one year yield a continuously compounded interest rate of 4 percent, and the standard deviation of the returns on the price of crude oil is 50 percent. Use the Black-Scholes model to calculate the maximum bid that the company should be willing to make at the auction Jet Black is an international conglomerate with a petroleum division

Answer 1

Bidding for the oil block is similar to purchasing a call option as participating in the auction provides the firm with an option (but not obligation) to obtain oil at $ 35 per barrel (cost of extraction) instead of the higher current market price of $ 58 per barrel. The maximum bidding price for gaining this option is the call option's fair value calculated as per the Black Scholes Model.

Underlying Asset Price = Current Market Price of Oil - $ 58 and Strike Price of Option = Cost of Extraction = $ 35 per barrel, Standard Deviation = Volatility = 50% and Tenure = 1 year and Risk-Free Rate = 4 %

Using an online financial calculator to solve for the option price we get:

Black-Scholes Option Calculator Spot Price (SP) Strike Price (ST) Time to Expiration (t) Volatility (v) Risk-Free Interest Rate (r) Dividend Yield (d) 58 35 Years 50 Calculate Results Call Price: $25.89

Maximum Bid Price = Fair Value of Call Option = $ 25.89