Analysis of Real Option Approaches for Oilfield Valuations

Abstract

More than three decades have passed since Stewart Myers coined the term “real options” and introduced this new paradigm into the investment science. In the following years a number of publications in both the finance and decision analysis literature hailed the benefits and power of Real Options for corporate investment decisions. In 2001 Copeland stated that “In ten years, real options will replace NPV (Net Present Value) as the central paradigm for investment decisions.” Now, eighteen years hence, the dominating valuation paradigm in the exploration and production industry still seems to be the classical NPV approach. Why? In the time period following the initial applications of real option valuation to oil & gas investments, a number of approaches were proposed for calculating the value of an uncertain investment. Unfortunately, the assumptions underlying these approaches and the conditions that are appropriate for their application are often not spelled out. Where they are spelled out or can be inferred, they differ from approach to approach and are often contradictory. In many instances, oil companies struggle with decisions pertaining to petroleum investment. The difficulty partially stems from the uncertainties in many of the inherent variables. Furthermore, conventional investment methods often fail to properly identify available opportunities. As commonly acknowledged, traditional valuation methods such as Discounted Cash Flow (DCF) and Net Present Value (NPV) analyses are unable to properly portray investment opportunities. Due to large uncertainties and hence risk in Petroleum Exploration and Production (E & P), investors are gradually turning to a more dynamic approach to investment decisions. Real Options Valuation involves a methodology for evaluating the value of an opportunity, of these Real Option approaches is presented in this thesis. In comparing the above-mentioned Real Options approaches, it is apparent that two types of Uncertainties may be considered: technical and market. In the study presented, an offshore petroleum lease project was discussed using the real options approaches.This research integrates the finance option theory with petroleum engineering projects, as well as project management. As such, it is shown that the petroleum industry could benefit from using the Real Options Valuation in their investment strategy, thus improving business Performance.