Model Answer
0 min readIntroduction
Decision-making in the face of uncertainty is a critical aspect of risk management, particularly in capital-intensive industries like oil exploration. The Expected Monetary Value (EMV) is a widely used technique to evaluate the potential outcomes of different choices, considering both the probability of each outcome and its associated monetary value. This approach allows companies to make informed decisions even when the future is uncertain. In the context of the Black Gold Oilfield Company, a systematic application of EMV will help determine the most financially sound strategy for exploring the potential oil reserves in the Bay of Bengal.
Understanding the Problem
The Black Gold Oilfield Company faces a decision regarding the exploration of a potential oil reserve. They have three options: (1) Drill directly, (2) Conduct a seismic survey first and then drill based on the results, or (3) Do nothing. We will use the EMV criterion to determine the optimal strategy.
Calculating Probabilities
First, we need to calculate the probability of hitting oil using Bayes' Theorem. Let 'O' represent the event of oil being present and 'S' represent the result of the seismic survey (Favourable or Unfavourable).
Probability of Oil (P(O)) = 0.25
Probability of No Oil (P(¬O)) = 1 - 0.25 = 0.75
Seismic Survey Probabilities (Given in the question):
- P(S=Favourable | O) = 0.6
- P(S=Unfavourable | O) = 1 - 0.6 = 0.4
- P(S=Favourable | ¬O) = 0.2 (Since P(Unfavourable | ¬O) = 0.8)
- P(S=Unfavourable | ¬O) = 0.8
Updated Probabilities using Bayes' Theorem:
- P(O | S=Favourable) = [P(S=Favourable | O) * P(O)] / [P(S=Favourable | O) * P(O) + P(S=Favourable | ¬O) * P(¬O)] = (0.6 * 0.25) / (0.6 * 0.25 + 0.2 * 0.75) = 0.15 / (0.15 + 0.15) = 0.5
- P(O | S=Unfavourable) = [P(S=Unfavourable | O) * P(O)] / [P(S=Unfavourable | O) * P(O) + P(S=Unfavourable | ¬O) * P(¬O)] = (0.4 * 0.25) / (0.4 * 0.25 + 0.8 * 0.75) = 0.1 / (0.1 + 0.6) = 0.1/0.7 = 0.143 (approx.)
Calculating Expected Monetary Values (EMV)
Now, we calculate the EMV for each decision path.
1. Drill Directly:
EMV = (Probability of Oil * Value of Oil - Drilling Cost) + (Probability of No Oil * -Drilling Cost)
EMV = (0.25 * 8000 - 1000) + (0.75 * -1000) = (2000 - 1000) - 750 = 1000 - 750 = ₹250 crore
2. Seismic Survey then Drill:
This involves two stages. First, the cost of the seismic survey. Then, based on the survey result, either drill or don't drill.
- If Seismic Survey is Favourable:
- If Seismic Survey is Unfavourable:
Cost = 300 crore + (0.5 * (8000 - 1000)) + (0.5 * -1000) = 300 + (0.5 * 7000) - 500 = 300 + 3500 - 500 = ₹3300 crore
Cost = 300 crore + (0.143 * (8000 - 1000)) + (0.857 * -1000) = 300 + (0.143 * 7000) - 857 = 300 + 1001 - 857 = ₹444 crore
EMV (Seismic Survey then Drill) = (P(S=Favourable) * EMV(Favourable)) + (P(S=Unfavourable) * EMV(Unfavourable))
P(S=Favourable) = (P(S=Favourable | O) * P(O)) + (P(S=Favourable | ¬O) * P(¬O)) = (0.6 * 0.25) + (0.2 * 0.75) = 0.15 + 0.15 = 0.3
P(S=Unfavourable) = 1 - 0.3 = 0.7
EMV = (0.3 * 3300) + (0.7 * 444) = 990 + 310.8 = ₹1300.8 crore
3. Do Nothing:
EMV = ₹0 crore
Optimal Decision
Comparing the EMVs:
- Drill Directly: ₹250 crore
- Seismic Survey then Drill: ₹1300.8 crore
- Do Nothing: ₹0 crore
Based on the EMV criterion, the optimal decision is to conduct a seismic survey first and then drill based on the results, as it yields the highest expected monetary value of ₹1300.8 crore.
Conclusion
In conclusion, the Black Gold Oilfield Company should prioritize conducting a seismic survey before committing to drilling. While drilling directly offers a positive EMV, the seismic survey strategy significantly increases the expected return by providing more information and reducing the risk of unproductive drilling. This decision aligns with sound risk management principles and maximizes the potential financial benefits for the company. The EMV analysis provides a robust framework for making informed decisions in uncertain environments.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.