Suppose a firm owns oil well assets. It is deciding how much oil to extract from its oil wells this year and next year. Production of oil costs $10 per barrel this year; next year, because of new labor contracts, it is estimated that production will cost $12 per barrel. Let p0 be the price of oil per barrel this year, and p1 the price of oil per barrel next year. The firm can invest any profits in other, non-oil assets that earn an interest rate of 7%; the firm can also borrow at this interest rate.
a) Suppose that p0 = $50 and while it is expected that p1 = $80. How much profit per barrel would the firm earn this year? How much next year? What is the discounted present value of next year's profit per barrel?
b) Given the data in (a), what action would you recommend that the firm take with respect to its oil assets? Explain the economic logic.
c) Suppose that the expectation was for p1 = $53 while p0 = $50 as in (a). How much profit per barrel would the firm expect to earn next year? What is the discounted present value of next year's profit per barrel?
(d) Given the data in (c), what action would you recommend that the firm take with respect to its oil assets? Explain the economic logic.
(e) Suppose the interest rate the firm at which the firm can borrow or invest is 2% instead of 7%. Does this change your answer to (d). Explain the logic underlying your answer.
(f) Suppose that p0 = $50 and the interest rate at which the firm can borrow or invest is 7%. What would the firm's expectation of p1 have to be in order for it to be in equilibrium, wishing neither to expand nor contract its oilfield holdings? Explain the economic logic.