The Pampa Oil Company operates oil and gas exploration throughout the panhandle of Texas. The firm recently was approached by a wildcatter named William "Wild Bill" Donavan with the prospect to develop what he thought was a sure thing. Wild Bill owned the lease and wanted to sell it to Pampa to meet some rather pressing gambling debts.
The exploration would involve efforts expended over the period of one year and cost $600,000 (which for simplicity we assume is paid at the end of the year).
Wild Bill is extremely confident that there are 20,000 barrels of oil to be found, and he has engineering and geological reports to support his view. The value of the proposition hinges on the price of oil, the cost of exploration, and the cost of extracting the oil. Pampa Oil is very familiar with exploration and production in the area and is confident about its cost estimates. Pampa Oil estimates that the exploration would involve efforts expended over the period of six months and cost $600,000 (which for simplicity we assume is paid at the end of the year).
Pampa Oil also feels confident that the cost of extracting oil will be no more than $8 a barrel. However, oil prices have been very volatile, and the experts in the economy predict that oil prices might hit $50 a barrel by year-end or drop back to $35 depending upon progress made in securing a lasting peace in the Middle East. Pampa Oil is, therefore, considering the possibility of deferring development of the oil field for six months. Waiting for six months will place Pampa Oil in a better position to determine whether to go ahead with exploration or not. The risk-free rate of interest is currently 5%, and the forward price of oil one year in the future is now trading at $40 a barrel. What should the investment proposal be worth to Pampa (you may assume a zero income tax rate)?
Available oil (barrels) 20,000
Oil Price Next Year
Forward price of oil for next year $40.00
Development cost $600,000.00
Extraction cost/barrel $8.00
Risk free rate of interest 5%
Income tax rate 0%
If the investment is hedged by selling the oil in the forward market
Revenue (hedged) $800,000
Less: Development cost (600,000)
Less: Extraction cost $(160,000)
Less: Taxes $-
Net Income ...
The value of an investment proposal is determined.