Homework answers / question archive / The Mackenzie Oil Co

The Mackenzie Oil Co

Business

Share With

The Mackenzie Oil Co. has recently completed its evaluation of a new structure (Juniper) and is satisfied that reserves of oil are sufficient to justify the installation of production facility costing $150 million. Furthermore, management is keen to proceed immediately in order to absorb available cash flow from the company’s Aspen Field, which has recently achieved peak production.

A further, adjacent structure, named the Rowan prospect, was discovered last year and has been the target for further seismic investigation. The Exploration Department is optimistic that commercial reserves will be demonstrated in the near future. Management accepts the current assessment that the probability of commercial reserves being identified in the Rowan structure is 35%; 

If this oil does exist, the production facility currently planned for Juniper would be inadequate for both reservoirs and, consequently, an expansion in production facility would be required. Alternatively, Mackenzie Oil could decide now to install a larger facility, with capacity for both reservoirs. This option is estimated to cost $225 million.

The drilling rig, Arbor 1, has been leased to drill a single appraisal well on Rowan this year and these results will certainly provide a better indication of the economic potential of the structure. The reliability of this appraisal well is predicted by the company to be around 0.6, meaning that whatever the prognosis, there is a 60% probability that it is correct. If the development decision is delayed until this appraisal result is available, the Juniper program would slip by a year and the company would face a larger short-term tax liability, equivalent to an additional current payment of $35 million. One further well is planned for the Rowan structure next year, but management is not prepared to delay the Juniper decision beyond the result of the first appraisal well.

The Mackenzie Oil management has decided to proceed with the Juniper Field development no later than the completion of the well currently being drilled by Arbor 1. There is, however a problem of deciding whether to proceed with a smaller capacity or to install a larger production facility.

1) Advise the management of Mackenzie Oil as to the optimum strategy in order to minimize the expected cost of the Juniper / Rowan Field development. Note that this requires the construction of a decision tree incorporating the logic of the problem, relevant cost information and probabilities. No revenue information is presented or required.