Expected Monetary Value and Farm out

Before we dive into probability and expected monetary value (EMV), we will introduce a
motivational problem from the petroleum industry. You are exploring the possibility of drilling a
potential new oil field. You can either do the drilling yourself, or you can farm out the drilling
operation to a partner. The field in which you are proposing to drill may or may not have oil
you dont know until you drill and find out. If you drill yourself, you take on the risk if the field
is not a producer, but if the field is a producer, you dont need to share your profits with anyone.
If you farm out the drilling operation, you are not exposed to any losses if the field is not a
producer but if the field is a producer, the drilling company will take the lions share of the
profits. Table 10.1 shows the net present value of the prospective oil field.
Table 10.1: Net Present Values of the Oil Field Problem
Field is Dry
Field is a Producer
Drill Yourself
-$250,000
$500,000
Farm Out
$0
$50,000
Clearly, if you knew the field was a producer you would want to drill yourself (and if you knew
it werent, then you would not want to drill at all). But you dont know this before you make
your drilling decision. What should you do?
Suppose that you had enough information on the productivity of wells drilled in a similar
geology to estimate that the probability of a dry hole was 65% and the probability of a producing
well was 35%. Do these probabilities make your life any easier?
These decision problems can be solved by calculating a quantity known as the expected
monetary value (EMV) basically a probability-weighted average of net present values of
different outcomes. Formally, the EMV is defined by determining probabilities of each distinct or
mutually exclusive outcome, determining the NPV under each of the possible outcomes, and
then weighting each possible value of the NPV by its probability. In mathematical terms, if Z is
some alternative; Y1, Y2, , Yn represent a set of possible outcomes of some uncertain variable;
X1, X2, , Xn represent the NPVs associated with each of the possible outcomes; and P(Y1),
P(Y2), , P(Yn) represent the probabilities of each of the outcomes, then the EMV is defined by:
EMV(Z) = P(Y1)X1 + P(Y2)X2 + + P(Yn)Xn.
The alternative with the highest EMV would be the option chosen. A decision-maker who
chooses among alternatives in this way would be called an expected-value decision-maker.
Some things to remember about probabilities:

A probability is a number between zero and one. So P(Yj) = 0.05 means that there is a 5%
chance of outcome j occurring. If P(Yj) = 0, it means that outcome j never occurs and if
P(Yj) = 1, it means that outome j always occurs.

If a set of outcomes is mutually exclusive (meaning that multiple outcomes cannot occur)
and exhaustive (meaning that the set captures all possible outcomes), then the

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probabilities of all outcomes in that set would be equal to one. Rolling a six-sided die
with the outcomes {1,2,3,4,5,6} is an example. This set of outcomes is mutually
exclusive because the face of the die cannot show two numbers at once (unless the die is
crooked). The set of outcomes is exhaustive since it contains all possible outcomes of the
die being rolled. In this case P(1) + P(2) + P(3) + P(4) + P(5) + P(6) = 1. The set of
outcomes {1,2,3} is an example of non-exhaustive outcomes, since the die could show a
4, 5 or 6 upon being rolled.
Now, back to our oil field problem. Well describe the problem again, using the language of
expected monetary value. There are two alternatives to drill yourself or to farm-out. The
uncertainty is in the outcome of the drilling process. The set of mutually exclusive and
exhaustive outcomes is {dry hole, producer}. These are the only two possible outcomes
regardless of whether you choose to drill yourself or farm-out. The NPVs of each alternative,
under each possible outcome, are shown in Table 10.1. To decide whether to drill or farm out,
you would calculate the EMV of each option as follows:
EMV (Drill) = P(dry hole) -$250,000 + P(producer) $500,000
= 0.65 -$250,000 + 0.35 $500,000 = $12,500.
EMV (Farmout) = P(dry hole) -$0 + P(producer) $50,000
= 0.65 -$0 + 0.35 $50,000 = $17,500.
In this case, you should choose to farm out the drilling operation.
The basic idea behind EMV is fairly straightforward, assuming that you can actually determine
the relevant probabilities with some precision. But the meaning of the EMV is a little bit subtle
and requires some degree of care in interpretation. Lets take a very basic situation a coin flip.
Suppose that we were to flip a coin. If it shows heads, you must pay me $1. If it shows tails, then
I must pay you $1. The EMV of this game, assuming that heads and tails have equal
probabilities, is $0. (See if you can figure out why, based on the EMV equation and the fact that
P(heads) = 0.5 and P(tails) = 0.5.) But if you think about this for a minute, how useful is the
EMV? If you play the coin-flipping game once, you will never ever have an outcome where the
payoff to you is $0. The payoff will either be that you gain or lose one dollar.
If you look at the EMVs from the oil-field problem, you will see the same thing. The EMV of
drilling is $12,500 but there is no turn of events under which you would wind up earning
$12,500 if you drill, it would either be that you lose $250,000 or gain $500,000. Similarly, if
you farm out you will never earn exactly $17,500. You will either lose nothing (payoff of $0) or
you will gain $50,000. So what does the EMV mean when it tells you that farming-out is the
better option?
Its important to remember that the EMV is a type of average. If you were to play the coin-flip
game or the oil-field game a large number of times under identical circumstances, and make the
same decision each time (i.e., to drill or to farm out), then over the long run you would expect to
wind up with $12,500 if you choose to drill and $17,500 if you choose to farm out. While the
EMV may be useful for gamblers or serial investors, using EMV needs to be done with some
care for stand-alone projects in the face of uncertainty.
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