Application of Real Options to Valuation and Decision-making in the Petroleum E&P Industry

Abstract

Abstract This study establishes a risk-neutral binomial lattice method to apply real options theory to valuation and decisionmaking in the petroleum exploration and production (E&P) industry under uncertain oil prices. The research is applied to the switching time from primary to water flooding oil recovery. First, West Texas Intermediate (WTI) oil price evolution in the past 25 years, from January 2, 1986 to May 28, 2010, is studied and modeled with geometric Brownian motion (GBM) and one-factor mean reversion price models. Second, production profile for primary and water flooding oil recovery for a synthetic onshore oil reservoir is generated using UTCHEM simulator. Third, the binomial lattice real options evaluation (ROE) method is established to value the project with flexibility in switching time from primary to water flooding oil recovery. Seven results and conclusions are reached: 1) for GBM price model, the assumptions of constant drift rate and volatility do not hold for WTI oil prices; 2) one-factor mean reversion model is better to fit WTI oil prices than GBM model; 3) the evolution of WTI oil prices in the past 25 years was according to three price regimes and since 2003, the world economy has increased its tolerance to higher oil prices and to higher price fluctuation from its long run price; 4) the established ROE method can be used to identify the best time to switch from primary to water flooding oil recovery; 5) with one-factor mean reversion oil price model and the most updated cost data, the ROE method finds that water flooding switching time is earlier than that from traditional net present value optimizing method; 6) the ROE results reveal that most of time water flooding should start when oil prices are high; and 7) water flooding switching time is sensitive to oil price models and to the investment and operating costs. The established ROE framework enhances the valuation and decision-making for petroleum E&P industry including when to switch from one enhanced oil recovery method to another and when to switch from conventional to unconventional hydrocarbon production.