REAL OPTIONS ANALYSIS OF MARGINAL OILFIELD DEVELOPMENT PROJECTS: THE CASE OF THE UKCS

REAL OPTIONS ANALYSIS OF MARGINAL OILFIELD DEVELOPMENT PROJECTS: THE CASE OF THE UKCS

By: Theophilus Acheampong

MSc (Econ) in International Business, Energy & Petroleum

December, 2010

Origins: Management flexibility

Understanding the concept─ The Real Options Approach to Investment─ Real Options and Total Value─ E&P as a Sequential Real Options Process

Case Study─ Assumptions─ Methodology─ Results

Summary and Conclusions

Appendix

OVERVIEW

Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum

University of Aberdeen, Aberdeen, U.K.

Origins: Management flexibility Many oilfield development projects are not static, they involve varying degrees of

risks and uncertainties. There are:― Geo-technical Risks e.g. Petroleum Reserves Risks― Market & Macroeconomic Risks (e.g. oil prices, inflation and discount rates)

How does management remain flexible in the midst of these uncertainties?

A modular development plan based on these unexpected events is what is needed.

Management can modular these development projects for example by waiting, expanding, contracting and abandoning.

This flexibility has value and capturing this value is what Real Options Analysis (ROA) entails



Understanding The Concept 1: The Real Options Approach to Investment

ROA is a modern methodology for economic evaluation of projects and investment decisions under uncertainty It complements (not substitutes) the corporate tools as yet.

ROA can be viewed as an optimization problem: Maximize the NPV (the objective function) subject to:

― Market uncertainties (eg.: oil price);― Technical uncertainties (eg., oil in place volume); and― Relevant Options (managerial flexibilities)

ROA considers the uncertainties and the options thus answeing 2 questions: What is the value of the investment opportunity (value of the option)?; and What is the optimal decision rule (threshold)?

ROA is the Application of Financial Option Valuation Techniques to Business Assets



Understanding The Concept 2 : The “Total Value” Approach



Understanding The Concept 3: Decision Tree Analysis & Real Options



Com

mit

Now

Wait and See

High Probability, λ

Low Probability, (1-λ)

Preserve Field

Develop Field

Oilfield Investment

High Probability, λ

Low Probability, (1-λ)

Preserve Field

Preserve Field

Develop Field

Develop Field

Work Backwards



Understanding The Concept 4 : (E&P as a Sequential Real Options Process)

Case Study 1



The project was aimed at:― Making an analysis of the DCF valuation methodologies vis-à-vis ROA― The ROA looked at the flexibility value of Deferral, Abandonment, and

Expansion Options during the relinquishment requirement period

A sample undeveloped marginal oilfield in the UKCS was utilized for this study

Marginal oilfields may prove uneconomic when developed under current circumstances.

This was chosen to highlight the significance of risks to the valuation method employed and the strategic importance of these options

The methodology for the study comprised of capital budgeting using the DCF via the Net Present Value(NPV)

For the ROA via the option pricing models (i.e. Black-Scholes and Binomial Lattice Models).

Case Study 2: Methodology

Abandonment Option Model

Deferral Option Model

Expansion Option Model

Key Input Data Base NPV ModelOption Valuation

Parameters

Fig 1: Valuation Methodology Summary

Key Input Data

• Revenues - Oil prices and Production volumes

• Costs - Tariffs, Development and Operating expenditures

• Other data - such as the UK Fiscal Terms and Discount Rate (Cost of Capital)

DCF Base Model

• Cash Flows – Pre and Post Tax Basis

• Base NPV, IRR, Payback Period Profitability Index

• DCF Sensitivity Analysis – e.g. Monte Carlo Simulation

Option Valuation Parameters

• Identify and model project uncertainties

• Estimate project volatilities using MC Simulation

• Calculate the other 5 determinants of the option value (e.g. strike price)

• Estimate option values using opting pricing methods (e.g. Binomial Lattice)

Embedded Project Options

• Deferral Option Base Value and Sensitivity Analysis

• Expansion Option Base Value and Sensitivity Analysis

• Abandonment Option Base Value and Sensitivity Analysis

Case Study 3: Main Results



PROJECT PROFITABILITY METRICSBase Case NPV NPV $M 262.30

IRR 65.7%Profitability Index 1.23

Real Options Analysis Values (Expanded NPV)

Deferral Option $M 317.21Expansion Option $M 270.13Abandonment Option $M 262.31

Deferral OptionExpansion Option

Abandonment Option

-

50

100

150

200

250

300

350

400

317.21

270.13 262.31

262.30 262.30

262.30

Real Options Analyis Value Static NPV

Valu

es

($ m

illio

n)Note: Expanded NPV = Base NPV + Option Value

Project Values with Flexibility (Base Case Scenario)

Summary & Conclusions



Real Options Analysis is an important step beyond DCF.

It is a powerful tool in project evaluation as it views projects as options to react to unfolding uncertainties.

ROA allows to us calculate the value of future flexibility. The total value of an investment is an important key stone for strategic decisions.

The results indicate that the value of the oilfield can be significantly improved by considering the flexibilities indicated by the embedded options

For example, using the options approach by incorporating a Deferment Option, the project value is 20.5% greater the static DCF value.

ROA presents advantages over the DCF valuation because: It creates the opportunity to maximize the upside potential and lower the

downside risks.

It accurately accounts for the project value

Thank You:

Questions?



APPENDIX

Classical Model of Real Options in Petroleum



Paddock & Siegel & Smith (1987-88) wrote a series of papers on valuation of offshore reserves.

It is the best known model for oilfields development decisions It explores the analogy financial options with real options

Option CalculationSimulation Continuous Discrete

Monte Carlo Simulation Black/Scholes & Derivatives Binomial Trees

+ Easy to understand

+ Applicable to all Real Options constructs

+ Mathematically elegant

+ Relatively easy to calculate manually

+ Easy to understand+ Applicable to all Real Options

constructs+ Simple Real Options

modelling+ Fast calculation

− Very laborious implementation

− Slow calculation− Delicate issues in valuation

of Real Options (correlations, probabilities) etc)

− Complex to very complex

− Hard to understand for practitioners− Limited applicability

− Very laborious implementation with Excel

− Interpretation of results not very intuitive



Spreadsheet Samples: NPV Analysis

Spreadsheet Samples: Deferral Option Analysis



Some Important Scientific Foundations of Real Options

REAL OPTIONS ANALYSIS OF MARGINAL OILFIELD DEVELOPMENT PROJECTS: THE CASE OF THE UKCS

Economy & Finance

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