The gas problem

Luis vivanco
Madrid
IE Business sCHOOL 7-november-2016
The natural gas conundrum
A local energy provider offers a landowner €180,000 for the exploration rights to natural gas on a
certain site and the option for future development. This option, if exercised, is worth an additional
€1,800,000 to the landowner, but this will only occur if gas is discovered during the exploration
phase. The landowner, believing that the energy company’s interest in the site is a good indication
that gas is present, is tempted to develop the field herself. To do so, she must contract with local
experts in natural gas exploration and development. The initial cost of such a contract is €300,000
which is lost forever if no gas is found on the site. If gas is discovered, however, the landowner
expects to earn a net profit of €6,000,000. The landowner estimates the probability of finding gas
on the site to be 60%.
1. Create a payoff table that specifies the landowner’s payoff (in euros) associated with each
possible decision and each outcome with respect to finding natural gas on the site.
2. Use a decision tree to identify the strategy that maximises the landowner’s expected net
earnings from this opportunity.
3. Perform a sensitivity analysis on the optimal decision, letting each of the inputs vary one at the
time plus or minus 25% from its base value and summarise your findings. In response to which
model inputs is the expected profit value more sensitive? (hint: inputs are the monetary
amounts AND the probability of finding gas estimates)
 Gas is found
60% €180,000+1,800,000 = €1,980,000
€ 1,260,000
40%
Sell rights Gas is NOT found €180,000

€ 3,480,000

Go it alone
Gas is found
€6,000,000
60%
€ 3,480,000
40%
Gas is NOT found € -300,000

Natural Gas
The aerial technology option

• A new, aerial, technology is more exact in determining if there is gas.

The technology has correctly predicted the finding of gas 75% of the
times when gas was found. It also predicted that no gas was to be
found 80% of the times when no gas was found.
• The owners of the technology are willing to use it for a share of the
profits if they found gas. They are also willing to put in the money to
do the initial drilling to prove their prediction. How many of the
profits would the landowner be willing to share? Assume the results
can be obtained before the landowner has to give an answer to the
energy company.
Aerial technology record

Gas found Gas not found

Predicts Gas 75% 20%
Predict Not gas 25% 80%
 Using Bayes’ theorem
Gas found Gas not found
60% 40%
Pred gas = 75% Pred gas = 20%

Pred Not gas =

25% Pred not gas = 80%

40% gas is NOT found, out of those 40 times, it predicts correctly that gas is not
going to be found 80% of the time (32). The other 20% it predicted that gas was going to
be found, but gas was not found (8). The two together add up to the number of times
when gas was found, independently of the prediction.
Resulting numbers

Gas found Gas not found Total

Predicts Gas 45 8 53

Predict Not gas 15 32 47

Total 60 40 100

Probability of finding gas if aerial technology predicts gas exists:

45/53= 84.9%
Let’s assume given the
two options, the investor
is risk neutral, and
decides to go it alone.
Then…
 Gas is found
60% €180,000+1,800,000
€ 1,260,000

Sell rights 40% €180,000

Gas is NOT found

Gas is found
60% €6,000,000
€ 3,480,000
Go it
alone Aerial 40%
picture € -300,000
Gas is NOT found
Aerial shows there is gas
84.9% €6,000,000 – x
€ 5,094,000
Predicts no gas
15.1%
€0
What should the landowner do?

 Having made the decision to go it alone, because she’s relatively risk neutral, her
BATNA (best alternative to a non-agreement) is going for the option of hiring the
exploration firm herself, which gives her an EMV of € 3,480,000. Thus, than
number should be her negotiation start point.
 She should propose to the aerial technology firm to keep the upside of the 3.48
million (5.094 million – 3.48 million).
 Where she risk adverse and had, initially, decided for selling the rights, her
BATNA would be north of the 180 k she gets for selling the rights independently
of whether gas is found or not. She could ask for anything between that and the
1.98 million she would stand to gain if gas was found.

Disclaimer: the points above are just my opinion, as this is not a negotiation class.