An oil company is considering the purchase of the leasehold drilling rights with 100% working interest on a large block of acreage which from available geologic data appears to have a potential oil structure. The bonus required to secure the drilling rights is $3,000,000. There are no seismic coverage in the area and a detailed survey is estimated to cost about $2,000,000. Given that the structure has oil, two separate oil reserves, a large size and a medium size reserve, are expected to be present in this field with the following estimated data for production rates and development costs.

Large Reserve
Initial Flow Rate (beginning of year 1):	3,050
Exponential Annual Decline:	20%
Oil Price:	$40.00
Oil Price Escalation Rate (after year 1):	1.50%
Royalty Rate:	25%
Oil Production Cost per Barrel:	$10.00
Other Operating Costs (per year):	$57,000
Operating Cost Escalation Rate (after year 1):	1.50%
Tangible Capital Cost:	$5,000,000
Yearly Depreciation Rate from year 1 (Declining Balance):	20%
Income Tax Rate:	30%
Discount Rate:	13%

Medium Reserve
Initial Flow Rate (beginning of year 1):	1,285
Exponential Annual Decline:	22%
Oil Price:	$40.00
Oil Price Escalation Rate (after year 1):	1.50%
Royalty Rate:	25%
Oil Production Cost per Barrel:	$11.00
Other Operating Costs (per year):	$35,000
Operating Cost Escalation Rate (after year 1):	1.50%
Tangible Capital Cost:	$3,000,000
Yearly Depreciation Rate from year 1 (Declining Balance):	20%
Income Tax Rate:	30%
Discount Rate:	13%

From a preliminary analysis of the prospect, the exploration team has suggested two possible exploration strategies:

Immediately after acquiring the leasehold drilling rights, start drilling an exploratory well on the basis of present geologic interpretations and extrapolations.

To be certain as to whether, a structure exists under the block of acreage, the company could spend $2,000,000 for seismic and defer decisions about drilling until they have reviewed the seismic data. Seismic is thought to be quite reliable in this area, so the only uncertainty here

involves whether or not a structure (and possible oil trap) exists. The exploration team assesses the odds as being about 50-50 that their geologic lead is, in fact, a structure. As a further complication the exploration team has indicated it may even be feasible to consider drilling a second exploratory well if the first well encountered a structure but tested dry.

The company management is interested in purchasing the acreage but feels that it is wise to first evaluate some of these alternate strategies and what-if scenarios before committing $3,000,000 for leases.

You are now given the task of evaluating the feasibility of spending this money for this block of acreage using the estimated NPV from each of these reserves. For this analysis you will use a decision tree to calculate the expected values for each alternative using the probabilities given in the following table:

Outcome	One wildcat drilled on geologic data	Two wildcats drilled on geologic data	One wildcat drilled on seismic data	Two wildcats drilled on seismic data
Discovery of Large Field	5%	7.5%	15%	20%
Discovery of Medium Field	5%	7.5%	15%	20%
Dry Hole	90%	85%	70%	60%

Hint: Do not consider the lease and the seismic survey costs in your NPV calculations.