Incorporating technical uncertainty in real option valuation of oil projects

Real options are a way of valuing projects such as oil fields, which involve irreversible investment decisions subject to uncertainty. Whereas discounted cash flow (DCF) analysis is based on fixed estimates of costs and revenues, and a predetermined development scenario, real options focus on project flexibility (e.g., being able to defer starting a project, or conversely, to accelerate its development, etc.). Early applications concentrated on flexibility to overcome uncertainty on financial parameters and tended to ignore uncertainty on technical parameters (such as recoverable reserves). In some cases, companies can reduce the latter by acquiring additional information and sequentially updating parameter values and then the estimate of the project's value. This paper addresses the question of how to evaluate the option to acquire more information. The natural way to incorporate the new data is by Bayesian analysis. Choosing a multivariate normal framework for this analysis considerably simplifies the computations but this distribution has symmetric upper and lower tail dependence. To overcome this limitation, we have developed a novel form of Bayesian updating based on Archimedean copulas. We present a case study on production enhancement that shows how to combine Bayesian updating and real options. In this study, the oil company has the option to gather information from a production logging tool (PLT) before carrying out a workover.

[1]  E. Ziegel,et al.  Geostatistics Wollongong '96 , 1997 .

[2]  R. McDonald,et al.  Investment and the Valuation of Firms When There Is an Option to Shut Down , 1985 .

[3]  J. Hull.  Options, Futures, and Other Derivatives , 1989 .

[4]  Eduardo S. Schwartz,et al.  Evaluating Natural Resource Investments , 1985 .

[5]  L. Trigeorgis.  Real Options: Managerial Flexibility and Strategy in Resource Allocation , 1996 .

[6]  John Campbell,et al.  Real options analysis of the timing of IS investment decisions , 2002, Inf. Manag..

[7]  Eduardo S. Schwartz,et al.  Investment Under Uncertainty. , 1994 .

[8]  H. Raiffa,et al.  Introduction to Statistical Decision Theory , 1996 .

[9]  Pieter T. Elgers,et al.  Beta Regression Tendencies: Statistical and Real Causes , 1979 .

[10]  Lenos Trigeorgis,et al.  Multi-stage real options: The cases of information technology infrastructure and international bank expansion , 1998 .

[11]  F. Black,et al.  The Pricing of Options and Corporate Liabilities , 1973, Journal of Political Economy.

[12]  C. Robert.  The Bayesian choice : a decision-theoretic motivation , 1996 .

[13]  Hyun-Woo Choi,et al.  Contingent claims valuation of optional calling plan contracts in telephone industry , 2002 .

[14]  D. Siegel,et al.  Option Valuation of Claims on Real Assets: The Case of Offshore Petroleum Leases , 1988 .

[15]  Michael Croft,et al.  Resolving Reservoir Uncertainty to Create Value , 1998 .

[16]  Richard Ebil Ottoo,et al.  Valuation of Internal Growth Opportunities: The Case of a Biotechnology Company , 1998 .

[17]  Richard J. Sullivan,et al.  Investment in internet banking as a real option: theory and tests , 2002 .

[18]  Lawrence Gallant,et al.  Using Learning Models to Capture Dynamic Complexity in Petroleum Exploration , 1999 .

[19]  Gonzalo Cortazar,et al.  Optimal Timing of a Mine Expansion: Implementing a Real Options Model , 1998 .

[20]  M. Slade.  Valuing Managerial Flexibility: An Application of Real-Option Theory to Mining Investments , 2001 .

[21]  J. P. Laine.  Option Valuation of Field Development Projects , 1997 .

[22]  R. McDonald,et al.  Option Pricing When the Underlying Asset Earns a Below-Equilibrium Rate of Return: A Note , 1984 .

[23]  Eduardo S. Schwartz.  The stochastic behavior of commodity prices: Implications for valuation and hedging , 1997 .

[24]  Margaret Armstrong,et al.  Option Pricing: Estimation Versus Simulation For Brennan & Schwartz Natural Resource Model , 1997 .

[25]  Hemantha S. B. Herath,et al.  REAL OPTIONS VALUATION AND ITS RELATIONSHIP TO BAYESIAN DECISION-MAKING METHODS , 2001 .

[26]  Delphine Lautier,et al.  Un modèle de structure par terme des prix des matières premières avec comportement asymétrique du rendement d'opportunité , 2001 .

[27]  Thomas E. Copeland,et al.  Making Real Options Real , 1998 .

[28]  Marco Antonio Guimarães Dias.  The Timing of Investment in E & P: Uncertainty, Irreversibility, Learning, and Strategic Consideration , 1997 .

[29]  E. Altman,et al.  Recent Advances in Corporate Finance , 1985 .

[30]  R. McDonald,et al.  The Value of Waiting to Invest , 1982 .

[31]  Alain Galli,et al.  Filtering in Finance , 2003 .

[32]  M. Lund.  Real Options in Offshore Oil Field Development Projects , 1999 .

[33]  Gonzalo Cortazar,et al.  Implementing a Real Option Model for Valuing an Undeveloped Oil Field , 1997 .

[34]  Ronald W. Spahr,et al.  Comparing mean reverting versus pure diffusion interest rate processes in valuing postponement options , 1998 .

[35]  Peter R. Rose,et al.  Risk Analysis and Management of Petroleum Exploration Ventures , 2001 .

[36]  R. Nelsen.  An Introduction to Copulas , 1998 .

[37]  A. Kemna.  Case studies on real options , 1993 .

[38]  Steinar Ekern,et al.  An option pricing approach to evaluating petroleum projects , 1988 .

[39]  H. Joe.  Multivariate models and dependence concepts , 1998 .

[40]  Alain Galli,et al.  Real Option Evaluation of a Satellite Field in the North Sea , 2001 .

[41]  Shmuel S. Oren,et al.  Integrating real and financial options in demand-side electricity contracts , 2001, Decis. Support Syst..

[42]  R. C. Merton,et al.  The Role of Contingent Claims Analysis in Corporate Finance , 1985, World Scientific Reference on Contingent Claims Analysis in Corporate Finance.

[43]  Benoit Couet,et al.  A Stepwise Example of Real Options Analysis of a Production Enhancement Project , 2002 .

[44]  Jacques Silber,et al.  Dispersion, Asymmetry and the Gini Index of Inequality , 1987 .

[45]  Onno Lint,et al.  Market entry, phased rollout or abandonment? A real option approach , 2000, Eur. J. Oper. Res..