Question

An oil company is drilling a series of new wells on the perimeter of a producing oil field. About 40% of the new wells will be dry. Even if a new well strikes oil, there is still uncertainty about the amount of oil produced: 30% of new wells which strike oil produce only 3,000 barrels a week; 70% produce 40,000 barrels a week. (a) Forecast the annual revenues from a new perimeter well. Use a future oil price of $100 per barrel. (b) A geologist proposes to discount the cash flows of the new wells at 10% to offset the risk of drilling but not finding oil. The oil company's normal cost of capital is 5%. Does this proposal make sense? Explain briefly why or why not

Answer 1

a) Weekly production from one new perimeter well

= 40% *0 + 60%* (30%*3000+70%*40000)

=17340 barrels

So, Annual forecasted revenue = 17340 barrels /week * 52 weeks * $100/barrel = $90,168,000

b)

The proposal to discount the cashflows at a higher rate makes sense as these cashflows are highly risky as compared to the normal cashflows of the business , Hence these must be discounted at a higher rate than the normal cost of capital