1. An oil well, offshore Lebanon, has an estimated reserve of 10 million barrels. An oil company has a three-year production sharing contract (PSC) to exploit the well before returning it to the government. Each year, starting now, the company can either extract 50% of the reserve or not extract any oil. The oil price now is $60/barrel. Forecasts of the oil price over the next three years are $65, $70, and $70/barrel. To simplify matters assume there are no fixed costs to start or stop production. The variable extraction cost is estimated to be as high as $60/barrel, since the well is in deep water. The PSC contract specifies that net revenues from the extraction would be shared 50-50 between the company and the government. The oil company discount rate is 25%/year. The government discount rate is 10%/year.
2. (a) In what year(s) should the oil company extract oil?
3. (b) Estimate the value of the oil well for the company.
4. (c) Estimate the value of the oil well for the government.
5. (d) Why is the company's discount rate much higher than that of the government?

Answer rating: 100% (QA)

Oil Well Production Strategy and Valuation Scenario Oil well reserve 10 million barrels Production sharing contract PSC 3 years Annual extraction option 5 million barrels or none Oil prices forecasted ... View the full answer