A company has the opportunity to bid for drilling rights

Reference no: EM13616181

A company has the opportunity to bid for drilling rights for one year on a tract of land. The cost of extracting the oil is $18 per barrel, and the current (and expected future) price of oil is $16 per barrel. Because drilling had a negative contribtuion margin, an NPV calculations says that the drilling rights have a negative NPV. Treating this issue like and option, from past history, we know the annual standard deviation of the price of oil is 30%. Given this volatitlity, a firm contemplating a bid for the drilling rights can expect that at some point the price may rise to a point that is profitable. The right to drill is like a call option. By paying the exercise price of $18, the firm had the right to receive one barrel of oil. The option lasts for one year until drilling rights expire. The risk free rate is 4%, what is the value of this drilling option? The firm expects the field to produce 10,000 barrels a day. Normal production occurs for all 365 days a year. What is the total value of this drilling option for 1 year?

Reference no: EM13616181

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