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Optimal Decision-Making in Oil Drilling: Analyzing EMV and Probabilities

This study explores the optimal strategies for oil drilling under uncertainty. Key concepts include Expected Monetary Value (EMV) calculation for drilling versus selling, probability assessments of land containing oil, and analyzing random events such as favorable or unfavorable soundings. The analysis concludes that leveraging sounding information increases EMV, guiding the decision to drill or sell based on prevailing probabilities. The methodology illustrates how to effectively utilize statistics to inform investment decisions in oil exploration.

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Optimal Decision-Making in Oil Drilling: Analyzing EMV and Probabilities

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  1. Quiz 2: Problem (a) Recommendation: Drill for oil.

  2. Quiz 2: Problem (b) • Let p be the probability of oil. • EMV(Drill) = 700 p – 100 (1-p) • EMV(Sell) = 90 • Sell when 700 p – 100 (1-p) < 90 Sell when p < 0.2375 Drill when p  0.2375

  3. Quiz 2: Problems (c), (d), and (e) • Random Events • Oil = the land contains oil • Dry = the land is dry • FS = favorable sounding • US = unfavorable sounding • P(FS|Oil) = 0.6, P(US|Oil) = 0.4 • P(US|Dry) = 0.8, P(FS|Dry) = 0.2

  4. Quiz 2: Problems (c), (d) and (e) P(FS) = 0.15 + 0.15 = 0.3 P(Oil|FS) = 0.15/0.3 = 0.5 P(US) = 0.10 + 0.60 = 0.7 P(Dry|US) = 0.6/0.7 = 0.86 P(Oil and FS) = 0.15 FS 0.6 US Oil P(Oil and US) = 0.10 0.4 0.25 Dry FS P(Dry and FS) = 0.15 0.2 0.75 US 0.8 P(Dry and US) = 0.60

  5. Oil (0.5) Oil (0.14) Dry (0.5) Dry (0.86) 1 2 3 Decision Tree for Problem f EMV(2) = (0.5)(670-130) = 270 800-100-30=670 Drill -130 FS(0.3) Sell 60 670 Drill US(0.7) -130 Sell 60 EMV(3) = (0.14)(670) + (0.86)(-130) = -18 EMV(1) = (0.7)(60) + (0.3)(270) = 123

  6. Optimal Policy • EMV(No Sounding) = $100,000 • EMV(w/Sounding) = $123,000 • Conclusion: • Pay for the sounding • If favorable drill • If unfavorable sell • EMV = $123,000

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