A Case Study for Comparison of Different Real Option Approaches in Petroleum Investments

Abstract

Abstract Many oil companies struggle with how to value investment decisions that carry a large amount of risk due to uncertainty. There are two key questions. How should value be adjusted to account for risk? And, what is the value of flexibility (or options) in managing uncertainty? Traditional project valuation techniques and metrics (Net Present Value based on Cash Flows that are discounted at the WACC, which is sometimes inflated for "risk") are incapable of answering these questions to the degree of accuracy required for many investment decisions. Real Options Valuation (ROV) is the extension and application to real assets of option-pricing tools that were developed to answer the same two questions in the finance sector. However, due to the differences between real and financial assets, the evolution of this "extension and application" has resulted in a number of variations of approach. These variations are the subject of considerable debate within the petroleum industry. In this paper we describe four approaches, and compare their results using a case study that is dominated by price uncertainty.