Capital Budgeting under Risk and Uncertainties^151
If he conducts a seismic experiment, he can learn about the underlying soil structure
before deciding whether to drill or not. The underlying soil structure in this case may
be one of the following types: no structure, open structure, or closed structure. If no
structure is discovered, the prospects of finding oil are bleak, if open structure is found
the prospects of finding oil are fair, and if closed structure is discovered the prospects
of finding oil are bright.
The decision tree corresponding to this situation is shown in Exhibit 6.13. It may be
noted that, as a convention, a decision fork is represented by a square and chance fork
by a circle.
The decision tree delineated, the next phase of analysis calls for gathering information
about probabilities and monetary values associated with various outcomes in the decision
tree. The wildcatter reviews his experiences, analyses statistics relating to oil discoveries,
and consults geological experts. He comes up with the following information:
Probability for Various Oil Bearing States: If he drills without conducting seismic
experiments probabilities for various oil bearing states are:
Oil bearing state Probability
Dry 0.50
Wet 0.25
Soaking 0.25
Probabilities for Various Soil Structures: If he conducts a seismic experiment he is
likely to find the underlying geological structures with probabilities mentioned against
them:
Geological structure Probability
No structure (NS) 0.40
Open structure (OS) 0.30
Closed structure (CS) 0.30
Relationship between the Underlying Structures and Oil Bearing States The
relationship between the underlying geological structures and oil-bearing states expressed
in terms of joint probabilities is as follows:
Underlying Geological Structure
Oil Bearing State No Open Closed Marginal
Structure Structure Structure Probability of
State
Dry 0.32 0.15 0.03 0.50
Wet 0.04 0.10 0.11 0.25
Marginal 0.04 0.05 0.16 0.25
Probability of
geological structure 0.40 0.30 0.30 1.00