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Case Study 19.2

Chi U. Ikoku continues his World Oil article on decision analysis in the petroleum industry (see Case Study 19.1) with a discussion of decision trees and their importance in solving decision problems much more complex than the examples and exercises of chapter 19. Nontrivial decision problems consist of not one but a sequence of major choices or decisions that must be made. Writes Ikoku: "In a complex decision problem involving a long sequence of alternatives, a formal procedure for decision analysis is necessary to array the alternatives so that economic ramifications of each are clearly delineated. This formal array also promotes effective internal communication. The decision tree analysis fits this criterion." To illustrate, Ikoku presented the following example of a drilling venture evaluation.

XYZ Enterprises has a nontransferable short-term option to drill on a certain plot of land. Two recent dry holes elsewhere have reduced XYZ's liquid assets to \$130,000; and John Doe, president and principal stockholder, must decide whether XYZ should exercise its option (i.e., drill) or allow it to expire. Complicating the decision problem is the fact that Doe may pay to have a seismic test run in the next few days, and then, depending on the results, decide whether to drill or not.

XYZ can have the seismic test performed for a fee of \$30,000 and the well can be drilled for \$100,000. XYZ usually sells the rights of any oil discovered. A major oil company has promised to purchase all of the oil rights for \$400,000.

The company geologist has examined the available geological data and states that there is a 0.55 probability that oil will be discovered if a well is sunk ( without a seismic test ). Data on seismic test reliability indicate that if the results are favorable, the probability of finding oil will increase to 0.85; but if the results are unfavorable, it will fall to 0.10. The geologist has also computed that there is a 0.60 chance that the result will be favorable if a test is made.

(a) From Figure 19.4, Construct the expected payoff for the action a1: Drill immediately

(b) From Figure 19.4, Construct the expected payoff for the action a3: Do not run seismic test, do not drill.

(c) The expected payoff for the action, a2: Run seismic test, then decide whether to drill, is not computed as easily as for action a1 and a3 because action a2 involves two different chance forks-the fork corresponding to the result of the seismic test………..

(d) The second steep is to determine the optimal action at each decision fork…………..

(e) If you have performed the second step is part d correctly, there should remain only two “clear” paths or options available to the decision maker in the upper portion…….

(f) Now that you have computed the expected payoffs for each of the three actions, apply the expected payoff criterion in the usual manner, that is, choose the action with the maximum expected payoff. What is the oil company’s decision?

 Subject Business Due By (Pacific Time) 07/20/2013 12:00 am
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