Southern Gas Company (SGC) is preparing to make a bid for oil and gas leasing rights in a newly opened drilling area in the Gulf of Mexico. SGC is trying to decide whether to place a high bid of $16 million or a low bid of $7 million. SGC, expects to be bidding against its major competitor Western Gas Corporation (WGC) and predicts WGC to place a bid of $10 million with a probability of 0.4 or a bid of $6 million with probability 0.6. Geological data collected at the drilling site indicates a 0.15 probability of the reserves at the site being large, a 0.35 probability of being average, and a 0.5 probability of being unusable. A large or average reserve would most likely represent a net asset value of $120 million or $28 million, respectively, after all drilling and extraction costs are paid. The company that wins the bid will drill an exploration well at the site for a cost of $5 million.
a. Develop a decision tree for this problem. Draw this tree by hand and include it along with your submission.
• Do not put any numbers (probabilities, costs, etc.) on your drawing.
• The tree should show the structure and logic of the decision process.
• Distinguishing between decision and chance nodes, and naming the various nodes and branches, is critical.
• Create a tree that is as general as possible – do not eliminate certain branches from consideration because of the specific values of the inputs as presented in the case.
• Recall that the key to success is determining what decision/event happens first, and then building out the tree in sequential order.
b. Implement your Decision Tree in Precision Tree. Then print out your solved decision tree on a single page and attach it as a part of your submission.
c. What is the optimal decision according to the EMV criterion?
d. Perform one-way sensitivity analysis showing how the optimal decision would change if the probability of WGC bidding $10 million varies from 0% to 100% in steps of 10%. Attach the Sensitivity Graph and Strategy Region with your submission.