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Theoretically, the basic decision rule is to always choose the branch having the highest expected value. In practice, however, capital-constrained companies often select a less desirable option due to capital requirements of a higher EV alternative.

Theoretically, the basic decision rule is to always choose the branch having the highest expected value. In practice, however, capital-constrained companies often select a less desirable option due to capital requirements of a higher EV alternative.

[[File:Rose__expected-value-and-chance-of-success__Fig_1.png|thumb|{{figure_number|1}}Development well decision tree problem.]]

[[File:Expected-value-and-chance-of-success_fig1.png|thumb|{{figure_number|1}}Development well decision tree problem.]]

Figure 1 shows a decision tree for a simple development well problem. The problem here is whether to drill a well at the edge of a developing oil field or to shoot a seismic line first to try to determine whether the location may be structurally low and wet and thus move the drill site to the most favorable location. There is also uncertainty about [[reservoir quality]], which cannot be resolved without drilling. The costs in this example are as follows: cost of seismic ($100,000), cost of deferring production to allow time to shoot, process, and interpret seismic ($25,000), cost of dry hole ($400,000), and mean present value of producing well ($800,000, including drilling costs). An analysis of this problem shows two options:

[[:file:Expected-value-and-chance-of-success_fig1.png|Figure 1]] shows a decision tree for a simple development well problem. The problem here is whether to drill a well at the edge of a developing oil field or to shoot a seismic line first to try to determine whether the location may be structurally low and wet and thus move the drill site to the most favorable location. There is also uncertainty about [[reservoir quality]], which cannot be resolved without drilling. The costs in this example are as follows: cost of seismic ($100,000), cost of deferring production to allow time to shoot, process, and interpret seismic ($25,000), cost of dry hole ($400,000), and mean present value of producing well ($800,000, including drilling costs). An analysis of this problem shows two options:

* ''Option A''

* ''Option A''

*: If you first shoot a seismic line, your staff sees the following possible outcomes: (1) a 33% chance of getting a negative seismic result (that is, a structural low) and aborting the project or (2) a 67% chance of getting an encouraging seismic result and therefore drilling the well in the most favorable location. Positive seismic results would be expected to change the odds to an 80% chance of a profitable producer and a 20% chance of a dry hole.

*: If you first shoot a seismic line, your staff sees the following possible outcomes: (1) a 33% chance of getting a negative seismic result (that is, a structural low) and aborting the project or (2) a 67% chance of getting an encouraging seismic result and therefore drilling the well in the most favorable location. Positive seismic results would be expected to change the odds to an 80% chance of a profitable producer and a 20% chance of a dry hole.

The solution to the problem shown in Figure 1 is option B. It is the preferred choice because it has the higher estimated present value ($262,000 versus $200,000). Thus, the value (or profit) to the project of the additional seismic is +$62,000. Note, however, that if the proposed seismic line costs $200,000, option A becomes the preferred choice ($200,000 versus $161,000), so it would be more cost effective to drill rather than to shoot.  

The solution to the problem shown in Figure 1 is option B. It is the preferred choice because it has the higher estimated present value ($262,000 versus $200,000). Thus, the value (or profit) to the project of the additional seismic is +$62,000. Note, however, that if the proposed seismic line costs $200,000, option A becomes the preferred choice ($200,000 versus $161,000), so it would be more cost effective to drill rather than to shoot.

==See also==

==See also==