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March 12th, 2018, 02:53 AM   #1
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A large multinational oil company is considering its strategy in the North Sea. The UK government has announced that a new drilling site in the North Sea will be offered for sale on a competitive tender basis, the site going to the company making the highest bid. Provisional exploration of the site indicates that, over its life, it can be expected to generate revenue of around £1,500 million if the oil reserves turn out to be high, but only £500 million if they turn out to be low. Seismic tests have indicated that the probability of the reserves is 0.60.

If the company is successful in its bid, it will also have to decide whether to construct a new oil rig for the site or to move an existing oil rig which is currently operating at an uneconomic site. The costs of the new rig are around £250 million and for moving the existing rig around £100 million. A new rig would be able to boost production by £150 million if reserve levels turned out to be high. The company has decided that if it is to bid for the site, the maximum bid it can afford at present, because of its cash flow situation, is £750 million. In the past, 70 percent of the company’s bids for such sites have been successful.

However, the company is also under pressure to refurbish some of its existing rigs for both efficiency and safety reasons. The £750 million could be used for this purpose instead. If the money is used for refurbishment, there is a 50 percent chance of increasing efficiency to generate a return on the £750 million of 5 percent, and a 50 percent chance of generating a return of 10 percent. If the decision to refurbish takes place after the bid has been made and failed, only £500 million will be available.

Last edited by skipjack; March 12th, 2018 at 05:12 AM.
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March 15th, 2018, 06:29 PM   #2
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If a bid of £750 million succeeds 70 percent of the time, it fails 30 percent of the time. Therefore a failed bid followed by refurbishing has a 15 percent chance at a return of 5 percent and a 15 percent chance at a return of 10 percent. The expected profit is a return of 7.5 percent, which is £56,250,000.

Now let's assume the company wins the bid and moves the old rig for expenses of £750 million + £100 million = £850 million. The expected value of the oil, which is good regardless of which rig is used, is £1,500 million * 0.6 + £500 million * 0.4 = £1,100 million. The expected profit is £1,100 million - £850 million = £250 million.

If reserves are high, building a new rig increases expenses by £150 million more than for an old rig and increases revenue by £150 million. That's a net profit of 0. If reserves are low, building a new rig increases expenses but not revenue. Building a new rig never makes a profit, so the old rig should be moved.

To conclude, going by expected value, the company wants to win their bid because this provides a higher profit than refurbishing. However, if the company wants to guarantee they make a profit, they should refurbish. Winning the bid, moving the old rig, and having reserves be low results in a loss of £850 million - £500 million = £350 million.
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