Appendix -- Flaw of Averages.pdf - Richard de Neufville

de Neufville + Scholtes D R A F T October 14, 2008Valuation of an Oil FieldConsider the problem of valuing a 1M barrel oil field that could be acquired in 6 months. It hasknown extraction costs of $75/bbl, and the best estimate of the price in 6 months is $80/bbl.However, the price is equally likely to remain at $80/bbl, drop to $70/bbl or rise to $90/bbl .If we focus on the average future price, the value of the field is $5 M (= 1M (80 – 75) )What is the value of the field if we recognize the price uncertainty? An instinctive reaction is thatthis value must be lower because the project is more risky. However, when you do thecalculation scenario-by-scenario you find that if the price is $10/bbl higher, the value increases by$10M to $15M. However, if the price is $10/bbl lower, the value does not drop by $10M to -$5Mas implied by a loss of $5/bbl when production costs exceed the market price. This is becausemanagement has the flexibility not to pump, and to eliminate the lost so the value of the field isactually 0 when the price is low. The net result is the actual average value of the field would be$6.67M, higher that is $5M estimate derived on the basis of the average oil price of $80/bbl.The field is worth more on average, not less. This manifestation of the Flaw of Averagesillustrates why it worthwhile taking flexibility into account in design. If management is notcommitted yourself to pumping, it can avoid the downside if the low oil price occurs while stillmaintaining the upsides. This flexibility increases the average value of the project compared to aninflexible alternative.1 Provide reference2 Provide references3 The undergraduate engineering curricula at leading European and Asia universities commonlyhave no room for economic or social studies. This is the case for example at the University ofCambridge, the Technical University of Delft, the ETH???, and the Tokyo Institute of Technology.In the United States, the accreditation boards require engineering undergraduates to take aquarter of their credits in some form of liberal arts. However, this material is rarely integrated intothe professional curriculum.Appendix: Flaw of Averages Page 6 of 6