Question
SWAN Petroleum Corp.holds a permit which entitles the company to explore and extract crude oil in a petroleum field. The field contains around 2 million
SWAN Petroleum Corp.holds a permit which entitles the company to explore and extract crude oil in a petroleum field. The field contains around 2 million barrels crude oil reserve. The permit only allows the holder to start extraction either now (t=0) or in exactly two years (t=2) at a total cost of $70 million (assume the cost remains constant regardless of time). The current crude oil price is $40/barrel and the price evolves following a binomial process. In each year of the next two years, the oil price may increase by 20% p.a. or decrease by 10% p.a. randomly. Assume the operating expense is $4/barrel and the company can complete extraction and sale once it decides to start. Risk free interest rate is 4% p.a.
Requirement: Determine whether it's optimal for the company to start extraction now or in two years.
Hint: the oil field is an asset whose value is equal to the total sales after the operating expenses.
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