Dynamic Decision Trees as an Alternative for Real Options Valuation

Abstract

Abstract This paper suggests a model to incorporate Real Options Valuation (ROV) to the decision-making process concerning E&P projects, through a robust, flexible and innovative technique: Dynamic Decision Trees (DDT). The proposed approach integrates Discounted Cash Flow (DCF), Decision Trees and Montecarlo Simulation into one practical methodology much easier to utilize and understand than the traditional binomial lattices. The DDT model is presented using as framework the valuation of developing the Sardinata field in Colombia. Given that the Net Present Value (NPV) of the Discounted Cash Flow associated to the project was negative and close to break-even, the decision to execute it was delayed, despite management's good feelings regarding production potential and high oil prices. However, by modeling the project via DDT, it was possible to calculate the value inherent in project's uncertainty and managerial flexibility, allowing decision-makers to apply the Real Options concept and make better informed decisions. Consequently, the decisions to obtain 3D seismic and drill 25 infill wells were triggered. Real Options are a direct extension of Financial Options, as well as its most common valuation methods. Therefore, the assumptions upon which this theory is built must also apply for Real Options Valuation. However, this does not occur when using these valuation methods in highly risky projects such as those of the Oil & Gas Industry. The authors offer an alternative solution for valuing real options in E&P projects, yet still complying with the assumptions that support the theory. Through the use of DDT it was possible to avoid limitations in volatility estimation and option valuation, leading to a far-reaching and more accurate application of the theory. DDT proved to be a simpler, more robust, and more flexible manner for valuing real options than the traditional binomial lattices when dealing with E&P projects.