Reference no: EM132964631

Question - The Pampa Oil Company operates oil and gas exploration throughout the panhandle of Texas. The firm was recently approached by a wildcatter named William "Wild Bill" Donavan with the prospect to develop what he thinks is a sure thing. Wild Bill owns the lease and wants to sell it to Pampa to meet some rather pressing gambling debts.

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 a period of one year and a cost of $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 per 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 on progress made in securing a lasting peace in the Middle East. Therefore, Pampa Oil is considering the possibility of deferring development of the oil field for one year. Waiting for a year will place Pampa Oil in a better position to determine whether to go ahead with exploration.

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. Is the option to delay development of the property valuable? You may assume a zero income tax rate.