A real options based model and its application to China's overseas oil investment decisions

Abstract

This paper applies real options theory to overseas oil investment by adding an investment–environment factor to oil-resource valuation. A real options model is developed to illustrate how an investor country (or oil company) can evaluate and compare the critical value of oil-resource investment in different countries under oil-price, exchange-rate, and investment–environment uncertainties. The aim is to establish a broad model that can be used by every oil investor country to value overseas oil resources. The model developed here can match three key elements: 1) deal with overseas investment (the effects of investment environment and exchange rates); 2) deal with oil investment (oil price, production decline rate and development cost etc.); 3) the comparability of the results from different countries (different countries' oil-investment situation can be compared by using the option value index (OVI)). China's overseas oil investment is taken as an example to explain the model by calculating each oil-investee country's critical value per unit of oil reserves and examining the effect of different factors on the critical value. The results show that the model developed here can provide useful advice for China's overseas oil investment program. The research would probably also be helpful to other investor countries looking to invest in overseas oil resources.