Introduction     Future Value     Present Value     Net Present Value I     Net Present Value II     Discount Rate   Expected NPV

   Decision Tree     Utility     Opportunity and Sunk Costs  Evaluating Oil Rights    Free Rider    Strategy

Expected NPV...

 

When you studied the NPV section, you may have realized that most of the examples assumed that the well would be 100% successful. But in real life—and in OilFinancier—there is no guarantee that any well will be successful (well actually in OilFinancier, there will be a few situations where success is 100% guaranteed). This section deals with the uncertainty of being successful when deciding to drill a well.



To start this analysis, I am going to first do NPV calculations for shallow, intermediate, and deep wells. I am going to use a 300-day period (the length of the seminar) and a discount rate of 0.5% per OF day. I get the following results:

 

Type of Well NPV ($)
Shallow 328,000
Intermediate 545,000
Deep 871,000

When you do your spreadsheet you should be fairly close to these values. Don’t worry about differences of about 2% or so; we probably made some slightly different calculations or assumptions, and such differences will not affect the ultimate financial decision. We will be using these figures in this table throughout the rest of the financial training.

Special Note: I have been making some technical changes to OilFinancier. The examples given in this finance section are based on the old version of OilFinancier. So if you see the examples not matching up to the rules, it is because the rules have changed a little. When I get the rules finalized, I will be rewriting this entire section. Sorry for any inconvenience or misunderstanding!



We are also assuming we are at the start of the seminar, which means we have no producing or dry wells to predict where the best chances of success based on OilFinancier Geology. Instead we must rely on OilFinancier Statistics for doing a financial analysis.

With no wells nearby, OilFinancier Statistics tells us that the probability of finding oil at the shallow depth is 19%, intermediate depth 16%, and the deep depth 9%. We have no other choice but to use these figures.

Shallow Well Analysis

If we drill a shallow well, we have a 19% chance of discovering a shallow pool and this pool will have an NPV of $328,000. Since 19% from 100% leaves an 81% chance we will spend $100,000 to find no oil at the shallow depth and. And since it is a shallow well, we cannot discover an intermediate or deep pool.

When this kind of uncertainty exists, financial people use an Expected NPV (E) formula:

E = S Pi ´ NPVi

where:

E = Expected Net Present Value

Pi = Probability of Outcome i

NPVi = Net Present Value of Outcome i

For the shallow well, we have two possible outcomes: the well will be successful or it will not. We can just then plug in the numbers into the formula:

E (shallow) = 0.19 ´ $328,000 + 0.81 ´ -100,000

Note that the NPV of the second term is negative. This is because the dry shallow well cost you $100,000 in "Day 1" of your analysis. Also note that the cost of drilling the successful shallow well is already incorporated in the NPV calculation, so you don’t have to subtract this cost for the first term.

Working through the numbers:

E (shallow) = 62,000 - 81,000.

= -$19,000

The fact that the Expected Net Present Value is negative tells you that you should not make this investment. But you may want to consider that your assumed discount rate may be too high especially this early in the seminar.

Now let’s look at drilling an intermediate well at the start of the seminar. We can discover a shallow pool (19%), we can discover an intermediate pool (16%), or we can drill a dry well (65%) [100% – 19% – 16%]. Working these numbers into the formula, we get:

E (intermediate) = 0.19 ´ $328,000 + 0.16 ´ $545,000 + 0.65 ´ -200,000

= 62,000 + 87,000 – 135,000

= $14,000

Now we have a positive value. The NPV calculation tells us that drilling an intermediate well early in the seminar is actually a profitable venture (at a 0.5% discount rate).

Lastly, we shall look at the prospects of a deep well. The probability of discovering a shallow pool is still 19%, intermediate 16%, and deep 9%. This leaves a 56% chance of finding a dry well. Here’s our formula at work:

E (deep) = 0.19 ´ $328,000 + 0.16 ´ $545,000 + 0.09 ´ 871,000 – 0.56 ´ -300,000

= 62,000 + 87,000 + 78,000 – 168,000

= $59,000

Another positive NPV! Drilling deep wells early in the seminar is profitable! Let’s compare the NPVs for the three types of well: Shallow = - $19,000, Intermediate = $14,000, Deep = $59,000. The largest NPV belong to the deep well, which tells us that the deep well is the best investment. But when we discuss a financial concept called utility later on, you might want to reconsider what the expected NPV calculations are telling you.

The next section, Decision Tree Analysis, gives you another tool to better apply expected NPV values.

 

 

Build Your Own Spreadsheet!

You will get more enjoyment and experience if you build an NPV spreadsheet to figure how good your deals are.

You will also do a lot better than those financiers running on "cowboy economics." There are deals that may fair but are actually significantly one-sided.

Maybe you can be an OilFinancier shark to take advantage of the naive and inexperienced financiers.

Copyright © - DAVE VOLEK PUBLISHING - All Rights Reserved
Contents cannot be reproduced in whole or in part, in any form, without the permission of the publisher
Site developed and managed by Gold Media Inc - Toll Free:  1-888-910-6800
 Top