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&lt;i&gt;Our company is considering development of some oil deposits off the coast of western Africa.  Through our agreement with the local government, we have access to three separate oil fields, but we can only pick one.  How do we value the fields and decide which one to pursue?&quot; &lt;/i&gt;&lt;p&gt;Large oil companies outsource just about every element of their E&amp;P processes: they rent many of their oil rigs, contract geologists for seismic testing, and use third-party shippers.  The primary activity they retain in-house that can offer them a competitive advantage is investment decision-making.  These companies commonly make multi-billion dollar bets, so they had better be very good at investment decision analysis.  This sample interview question represents a very typical analysis that a finance person in an oil company would undertake, as well as the analysis that the company&#39;s lenders and consulting advisors might conduct.  &lt;p&gt;&lt;b&gt;Background&lt;/b&gt;  &lt;p&gt;Start by gathering background information on the situation, which is only very generally described in the question.  Your interviewer may offer up some of this information, but you will likely need to figure out the right questions to ask to solicit this information.   A good approach is to begin your response by stating, &quot;I&#39;d like to begin by asking a series of questions to gather more information on the situation so that I can determine the best solution methodology.&quot;&lt;p&gt;&quot;  Big Oil Company purchased production rights from the government of the African country.  Its agreement provides for royalty payments to the local government for any oil that is actually extracted.  &lt;p&gt;&quot;  Oil fields have very high internal pressure, and much of their contents would gush out very quickly if it could.  However, wells are drilled and gathering pipelines are built with an economical width and capacity that ends up constraining the extraction rate.  As a result, oil flows out of the well at a more constant rate over a longer period of time (See Figure 2.4).  When you evaluate a given oil field, you must take the binding constraint into account to determine how much oil would actually flow, and when--oil extracted today is usually worth more than oil extracted in the future, due to the time value of money.  &lt;p&gt;&quot;  Big Oil Company conducted seismic tests at each field location in order to verify the presence of oil.  However, such testing can produce false positives.  Based on the conditions at each site, engineers can calculate a probability of geological success for each oil field--in other words, a probability that the identified oil below the ocean floor in fact exists.  &lt;p&gt;&quot;  Big Oil Company&#39;s development committee has authorized the funding of the development of just one of the African offshore fields.  Similar to most exploration and production companies, Big Oil prefers to evaluate prospective projects in terms of both Net Present Value and Investment Efficiency (NPV divided by capital investment).Approach&lt;p&gt;Now that you better understand the context for the interviewer&#39;s question, you can explain your approach to solving the problem.  It is always best to announce beforehand the method you intend to use, so you appear organized and your thought process clear.   A statement such as the following will score you big points: &quot;I would recommend that we calculate an NPV for each of the three fields, taking into account potential oil volume extracted, operating costs of the well, and capital costs to develop the field.  We will need to multiply potential revenues and operating costs by the probability of success in each case.  I think it would be interesting to look not only at NPV and IE, but also at the magnitude and probability of potential losses in each case, since NPV just reflects the expected outcome but not the distribution of possible outcomes.&quot; &lt;p&gt;&lt;b&gt;Data&lt;/b&gt;&lt;p&gt;In order to complete the calculations you propose, you need a fair amount of input assumptions.  In some cases, the interviewer (when asked the correct question) will produce a prepared set of data assumptions for you to work with.  Alternatively, you can simply make your own educated assumptions in order to do the calculations.&lt;p&gt;&quot;  Production for any of the three fields would start in 2008, after well and trunkline construction is completed.  It will then take 2 years to reach peak production volume.  Decline from peak to zero production also lasts 2 years.  (See Figure 2.5)&lt;p&gt;&quot;  Big Oil Company uses a standard flat price of oil in its valuation models: $20/barrel.  (Oil companies are fanatically secretive about their host government royalty agreements and their oil market price forecasts; this price assumption incorporates both the complex royalty agreement and the company&#39;s proprietary market price outlook.)&lt;p&gt;&quot;  Big Oil Company&#39;s discount rate is 10% (i.e., the accounting factor the company chooses to compare future cash flows to today&#39;s dollars).  Normally, you would need to discount each year&#39;s cash flow individually by that year&#39;s appropriate discount factor.  To save you calculation time, your interviewer provides you with a composite discount factor that should be applied to each field&#39;s total revenue over time.  &lt;p&gt;&quot;  We assume no taxes.&lt;p&gt;&lt;b&gt;Calculation Details&lt;/b&gt;&lt;p&gt;Now that you have the requisite data, you can proceed with calculating the NPV for each field: &lt;p&gt;1.  Calculate the potential lifetime oil production volume from each of the three fields, which is the area under the curves in Figure 2.5.  &lt;p&gt;2.  Multiply each field&#39;s volume by $20/barrel to yield each field&#39;s potential lifetime undiscounted revenue.  &lt;p&gt;3.  Multiply by the composite discount factor to yield the potential lifetime discounted revenue.  &lt;p&gt;4.  Finally, multiply by each field&#39;s probability of success to yield the expected lifetime discounted revenue. &lt;p&gt;  5.  For operating costs, take the lifetime cost and multiply by the composite discount factor.  Then, make sure you also multiply by the probability of success--remember, if the well fails, then not only do you not have any revenue, you don&#39;t incur the associated operating costs either!&lt;p&gt;6.  Subtract the capital and expected operating costs from expected revenue to arrive at the expected NPV for each field&lt;p&gt;7.  Divide NPV by initial capital cost to yield the investment efficiency (IE) index. &lt;p&gt;You will end up with the following results:&lt;p&gt;The key to getting these calculations right is to remember to incorporate probability of success.  When we value many assets, we simply use revenue and operating cost assumptions without any further adjustment.   In the case of oil wells (and any other investment that has a possibility of totally failing), it is crucial to understand the probability of ever getting those projected revenues and incurring those projected costs.  To talk about expected value, we must multiply everything in the future by the probability of success.  Paying the capital costs, in contrast, is not a function of whether the oil ends up being extractable or not, so we don&#39;t adjust those.&lt;p&gt;&lt;b&gt;Conclusions&lt;/b&gt;&lt;p&gt;Don&#39;t stop with doing the calculations, as the most important part of a good answer is interpreting and summarizing the results.  There are many observations you can now make about the choice before Big Oil Company: &lt;p&gt;&quot;  All three fields are attractive investment opportunities, as they have positive NPVs. &lt;p&gt;&quot;  Field 2 has the highest NPV.  In other words, it is expected to bring in the most profit to Big Oil Company. &lt;p&gt;&quot;  Field 1 has the highest IE.  In other words, it is expected to bring in the most profit to Big Oil Company per dollar invested. &lt;p&gt;&quot;  Field 3 has an NPV very close to that of Field 2, but a much lower IE.  Big Oil Company would have to put up a lot more capital to generate the same bottom-line impact as with Field 2. &lt;p&gt;&quot;  We can also calculate expected losses for each of the fields:  probability of failure multiplied by capital cost.   For example, Field 1 has a 50% probability of losing its $800 million capital investment--an expected loss of $400 million.  Similarly, Field 2 has a $900 million expected loss, and Field 3 $300 million. &lt;p&gt;&quot;  While Field 2 yields the highest NPV and a high IE, it also has the lowest probability of success, at 25%, and the highest expected loss.   &lt;p&gt;-- Depending on Big Oil Company&#39;s risk appetite, the company may want to consider developing Field 3, which has a high NPV, yet has the lowest expected loss.  However, if Field 3 does fail, Big Oil Company would not recover any of its $1.5 billion investment.  &lt;p&gt;-- Risk aversion might also steer us to prefer Field 1, which has a fairly low expected loss ($400 million), the lowest potential loss ($800 million), the highest investment efficiency index (1.9), and a positive NPV. &lt;p&gt;Depending on Big Oil Company&#39;s risk metrics, the &quot;right answer&quot; could conceivably be any one of the three available oil fields.  What is important is not that you pick one as your answer, but that you walk through the pros and cons of each choice, and demonstrate that you can think about value along a number of dimensions. &lt;p&gt;Additionally, to take your response to a valuation question like this from good to great, you can point out other possible project risks and propose some creative alternatives: &lt;p&gt;&quot;  How much political risk is there?  Is there a chance the local government could pull out of its agreement with Big Oil Company midway through the process, leaving the investment stranded and unrecoverable? &lt;p&gt;&quot;  Does the proposed development impact any local populations in a way that might incite protests?  Social turmoil is bad PR for Big Oil, and causes financial losses from operational disruptions--not to mention the injustice ofnegative impacts on the host country&#39;s inhabitants. &lt;p&gt;&quot;  Are there design modifications we can make to ensure that, whichever field is developed, the operation has minimal environmental impact?  Have we factored in the expected costs of environmental mitigation into our project valuation? &lt;p&gt;&quot;  Is there additional testing we can do to raise our confidence in the presence of a large oil deposit in any of the fields?  In particular, if we had more confidence in Field 2&#39;s success, it could emerge as the clear winner for development.   &lt;p&gt;&quot;  Perhaps Big Oil Company could create a partnership or otherwise raise the additional capital needed to invest in more than one field.  Investing in two fields would increase the overall probability of success with at least one field.  For example, if we were to invest in both Fields 1 and 2, and we assumed their probabilities of success are independent, our chances of success would increase to 63% (1--50%*75%), which is higher than either of the two fields alone.  &lt;p&gt;

Derek Loosvelt

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