Futures-Based Modeling of the Oil Price for Realistic E&P-Project Valuation

Abstract

Abstract The net present value of an E&P-project is still the most important investment criteria in oil field acquisitions. Besides the discount rate assumption and the estimation of the strategic value of an E&P-project, the oil price assumption is the most important input parameter in E&P-project calculations. Even small variations in the oil price assumption can have large influence on the resulting project value. Therefore, for a realistic E&P-project valuation it is critical to use sophisticated methods for the estimation of the future oil price. In the past, it was common practice to simply assume a fixed value for the long-term oil price (flat price); others use forward curves as a forecast (floating price). In probabilistic calculations (e.g. in Monte Carlo simulation) and in using the option pricing theory for valuing real options, stochastic processes are modeled. Here, the oil price is predominantly considered as to follow a Geometric Brownian Motion or a type of a Mean Reverting Process. This paper presents an improved concept for modeling short- and long-term oil prices. The method is based on the premise that forward and future prices are the markets best guess of future oil prices. The future or forward curve is utilized as the expected value curve for the Mean Reverting Process. Thus, the oil price is modeled in a way that makes the resulting oil price assumption suitable for incorporating it in traditional net present value calculation as well as in sophisticated real option valuations. On the one hand for the discounted cash flow method it is critical to use reasonable short- and long-term values for the oil price, on the other hand for real options valuation it is necessary to model the oil price stochastically. The presented improved method fulfils both basic requirements and is therefore a strong improvement to common E&P-project valuations.