More Oil: Chevron, the number 2 U.S. oil company, was facing a tough decision. The new oil…

More Oil: Chevron, the number 2 U.S. oil company, was facing a tough decision. The new oil project dubbed “Tahiti” was scheduled to produce its first commercial oil in mid-2008, yet it was still unclear how productive it would be. “Tahiti is one of Chevron’s five big projects,” said Peter Robertson, vice chairman of the company’s board, to the Wall Street Journal.8 Nevertheless it was unclear whether the project would result in the blockbuster success Chevron was hoping for. As of June 2007 $4 billion had been invested in the high-tech deep sea platform, which sufficed to perform early well tests. Aside from offering information on the type of reservoir, the tests would produce enough oil to just cover the incremental costs of the testing (beyond the $4 billion investment).

Following the test wells, Chevron predicted one of three possible scenarios. The optimistic one was that Tahiti sits on one giant, easily accessible oil reservoir, in which case the company expected to extract 200,000 barrels a day after expending another $5 billion in platform setup costs, with a cost of extraction of about $10 a barrel. This would continue for 10 years, after which the field would have no more economically recoverable oil. Chevron believed this scenario had a 1-in-6 chance of occurring. A less rosy scenario, twice as likely as the optimistic one, was that Chevron would have to drill two more wells at an additional cost of $0.5 billion each (above and beyond the $5 billion setup costs), in which case production would be around 100,000 barrels a day with a cost of extraction of about $30 a barrel, and the field would still be depleted after 10 years. The worst-case scenario involves the oil being tucked away in numerous pockets, requiring expensive water injection techniques, which would involve upfront costs of another $4 billion (above and beyond the $5 billion setup costs) and extraction costs of $50 a barrel; production would be estimated to be at about 60,000 barrels a day for 10 years. Bill Varnado, Tahiti’s project manager, was quoted as giving this least desirable outcome odds of 50-50.

The current price of oil is $70 a barrel. For simplicity assume that the price of oil and all costs will remain constant (adjusted for inflation) and that Chevron faces a 0% cost of capital (also adjusted for inflation).

a. If the test wells would not produce information about which one of three possible scenarios would result, should Chevron invest the setup costs of $5 billion to be prepared to produce under whichever scenario is realized?

b. If the test wells do produce accurate information about which of three possible scenarios is true, what is the added value of performing these tests?


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