An oil company owns an oil field which can produce 1 million barrels of oil in total. The production cost is $50.00 per barrel. The oil price is $40.00 per barrel now. It will either increase to $55.38 per barrel or decrease to $27.48 per barrel next year, with equal likelihood, and will grow at 1.49% per year perpetually. The risk-free rate is 1.49%. (Here, the price and risk-free rate are all in real terms.) The oil price risk is not diversifiable. The company can either extract oil now (year 0) or next year (year 1). It can also decide to abandon the field at no cost.

(a) What is the NPV of the oil field under the optimal production/abandonment strategy?

(b) If the company does not have the abandonment option, it must produce oil either now (year 0) or next year (year 1), regardless of the oil price. What would be the value of the field in this case (i.e., without the abandonment option)?

(c) How much is the abandonment option of the oil field worth?

Answer rating: 100% (QA)

a NPV of the Oil Field with Abandonment Option Step 1 Calculate the Expected Future Oil Price Year 1 ... View the full answer