Now our boss ups the offer: "Let’s flip a coin. If it’s heads, we will double your salary and add another 10% for this month; if tails, you work for free." Now you can see your opportunities have increased, so you do bit financial analysis. Assuming you make $1000 a month, you have a 50% chance of working for $2200 and a 50% chance of working for nothing. When we do the expected NPV calculation, we find that this deal actually increases our pay to $1100 a month.

But most of us still won’t take this deal even though it would be profitable for us to take it. When we do the analysis, we start thinking: "what if I lose?" We have bills to pay, our families to take care of, and our hobbies to enjoy. We may be able to work one month for free, but there still is a 25% chance of working two months for free—and a 12.5% chance of working three months for free. We look at the gain of an extra of 10% per month and say: "Going without a paycheck is not worth this 10%."

But when the boss says: "OK, if it’s heads, we will double your salary and add another 25% for this month; if tails, you work for free," some of us will take this deal. And some of us will stay with the secure choice. As our boss increases the "profit" of this gamble, we find our risk profile, often called "utility." Each one of us has a different utility because we have different values about risk and reward.

Just one more example: Our boss says: "If it’s heads, we will double your salary and add another 25% for this month; if tails, you work for free." But you have $50,000 sitting in your bank account.

If you have come this far in the OilFinancier website, I think it’s safe to assume that you like some risk in your life and are willing to take that risk if you can see some financial reward. With the $50,000 in your bank account, most of us would take our boss’s offer. Losing the coin toss—even three months in a row—is not going to affect our basic needs. We will know that over a year’s time, we will earn a bigger salary just by gambling with our boss each month. The $50,000 has actually changed our utility and made it possible for us to gamble on our paycheck.

In OilFinancier you are going to be faced with decisions based on utility for at least the first half of the seminar.

Let’s consider the wildcat example we did earlier of drilling a shallow well with another financier. If this well is successful, we will immediately drill another well. We could be spending $200,000 in a very short time. If our share of play is 50%, we will wipe out the $100,000 we started the game with. Even though our Trainee’s salary of $1000 per day will prevent us from going into the red, we can go from a mediocre cash position to a poor cash position very quickly. If this play turns bad, we only have one more play to make before hitting red ink and being sidelined for a time. That is your OilFinancier utility staring you in the face.

I could have designed the seminar so that utility would only be a minor concern, but this is fairy-tale economics. The oil tycoons of the past had to face utility in their dealings. And today’s petroleum executives, whether they realize it or not, also deal with utility on a daily basis. Consider working with utility as part of your training for this seminar.

In my studies of financial utility, I found that, if anything, utility was a difficult thing to quantify. I did find some formulas, but I couldn’t quite see how these formulas fit with OilFinancier. So I invented this formula:

U = P_(play) ´ # of Times

where:

U = the utility value of the play

P_(play) = the probability of the play succeeding

# of Times = the number of Times you can make this play in the short term.

I’m going to use the shallow-shallow example to explain these terms better.

According to OilFinancier Statistics, there is a 19% chance of discovering a shallow well on the wildcat. If a shallow oil well is discovered, the adjacent square has a 55% chance of discovering a shallow pool. The probability of both these wells discovering oil is 10.4% [0.19 ´ 0.55], which is our desired outcome for this play. So we plug 0.104 into the variable P_(play).

The "# of Times" is basically the number of times you can make this kind of play in the short term. It is calculated by the following steps:

1. Assessing your cash position (in this example, $100,000 you got to start of the seminar).
2. Assessing how often you want to make a deal (we will assume every 15 days).
3. Assessing your cash flow (at the start, you have only your Trainee’s salary of $1,000 per day).
4. Multiplying (2) by (3) for $15,000.
5. Adding (1) to (4) for $115,000, which is your short-term cash position.
6. Determining the expected cost of the project. The project will cost at least $100,000 to drill the first well. There is a 19% chance that you will drill a second for another $100,000. The expected cost, therefore, is $119,000 [$100,000 + 0.19 ´ $100,000].
7. Determine your share of this cost. Assuming you have to pay 50%, your cost is $59,500.
8. Dividing (7) into (5) for 1.93, the number of times you can afford to make a similar deal in the short term.

Your utility value, as determined by the formula I invented, is:

U = 0.104 ´ 1.93

= 0.20

Note that this 0.20 figure is, by itself, neither good nor bad. It should be used to compare different projects based on their utility. The higher the utility value, the better the investment.

Note that the profitability conditions are not part of this utility calculation because the project’s profitability has already been determined in the expected NPV calculations. In other words, do the expected NPV calculation first. If the project is profitable (i.e. the expected NPV is positive), then do the utility analysis. If the NPV is not profitable, there is no need to do the utility analysis because the negative expected NPV already tells you to stay away from the project.

Let’s go back to our decision-tree analysis. In this analysis, we found that working up a wildcat play to drill two deep wells is actually more profitable than drilling a wildcat play with two shallow wells. According to this analysis, you should do the deep play, not the shallow play.

But you will recognize that with your limited cash and limited cash flow, missing that deep pool is going to leave you in the poor house for a very long time. Other financiers will move way ahead of you by the time you get your cash flow positive. Let’s look at the utility of the deep-deep project:

• Probability of the first well finding oil at the deep depth: 9%
• Probability of the second well finding oil at the deep depth, if the first is successful: 58%.
• Probability of the play being successful: 5.2% [0.09 ´ 0.58]. Note that I did not consider finding oil at the shallow or intermediate depths being a successful conclusion to a deep-deep play.
• Amount of cash and short term cash flow: $115,000.
• Expected cost of this project $327,000 [$300,000 + 0.09 ´ $300,000].
• Your share of this project at 50% cost: $163,500.
• Number of times you can make this kind of play in the short term 0.703 [$115,000 ¸ $163,500].
• Utility of the deep-deep project: 0.04 [0.052 ´ 0.703].

The utility analysis is telling you that, from a cash position, the better project for you is the shallow-shallow play (E₍₁₊₂₎ = $25,000, U = 0.20), not the deep-deep project the decision-tree analysis is telling you (E₍₁₊₂₎ = $190,000, U = 0.04). The shallow play or well has a better chance of being successful as well as enabling you to make a similar play more often in the short term. In other words, it will not hurt your short-term cash position as much.

As I alluded to earlier, getting a numerical value on utility seems to be a difficult process even for the best of financial experts. And I have to admit that my formula is not prefect. But rather than invent an even more convoluted formula, I would encourage you to use my formula throughout the game. As you gain more experience, you should find a utility value that satisfies your risk profile. If you are offered a project that looks good from an NPV perspective, you should know by its utility value whether to participate now or to wait to allow your cash to build up while, at the same time observing what other opportunities are presented to you.

As the seminar progresses and you drill successful wells, you will start seeing cash flows of $15,000 per day or more. Because of this increased cash flow, you will be seeing higher utility values. This trend is telling you that utility is not as important to your current decisions as it was in the early part of the game. At these times, you can afford to rely mostly on the expected NPV calculations and decision tree analysis to tell you what to do. Finding the cash to do these projects will not be as much of a problem—like having the $50,000 in your bank account to gamble your paycheck with your boss.

Oil executives like to talk a lot about "spreading the risk". To their risk of capital investments, they partner in each other’s oil plays, similar to what you will be doing (and forced to do) in OilFinancier.

But spreading the risk is nothing but improving the utility of a play. In the shallow-shallow project, we calculated a utility of 0.20 if two partners are sharing equally in the play. If the play has four equal partners, our cost decreases to $29,750. Given our short-term cash position, we can now make this play 3.86 times, which increases our utility value to 0.40. Our utility analysis tells us the four-partner project is better than the two-partner project.