Question
Analysts at Shell are considering how much to bid in a government auction for drilling rights in a new lease area in the Gulf of
Analysts at Shell are considering how much to bid in a government auction for drilling rights in a new lease area in the Gulf of Mexico. Using forward prices for oil, the analysts have calculated the present value of cash flows from drilling in the area to be $20 million. Based on the companys recent experience in similar auctions, the analysts do not expect Shell to be able to win the auction unless it bids at least $25 million, which implies at best an NPV of negative $5 million. Therefore, the analysts suggest not participating in the auction. However, the CEO is not convinced. In her words, Our NPV calculation is based on oil forward prices from the futures market. I have found the futures market to be quite unreliable in predicting where oil prices are headed. I think that oil prices will be quite high over the next several years, implying that our present value estimate is too low. I think that a more accurate estimate of the value of cash flows from drilling is $30 million, and we should certainly be willing to pay $25 million to win. Is the CEOs argument valid? Please provide the rationale behind your answer.
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