Real options approach for a staged field development with optional wells

Abstract

With the decreasing average size of new discoveries in mature production areas, the uncertainties in the base of oil field investment decisions are continually increasing. Fewer appraisal wells, which allow to decrease the amount of subsurface uncertainty, are typically drilled before the development of a small field compared to large fields. In this context, novel solutions must be established to commercialize small discoveries under technical and market uncertainties. In such conditions, managerial flexibilities, which enable to change the course of the project in the event of new information acquisition, must be critically considered in the investment valuation process. Combining the real options approach and decision analysis, we establish a novel model to identify the additional value created by a sequential drilling strategy for field development under oil price and resource uncertainty. In particular, we capture the sequence of the key investment and operating decisions pertaining to a marginal field development in cooperation with an oil industry partner, which corresponds to a synthetic yet realistic project case. By considering the flexibility in dividing the production well drilling into two stages, we adopt the least-squares Monte Carlo algorithm to evaluate the option to wait to expand the production by drilling additional wells. Furthermore, we identify the conditions in which the staged (phased) development is preferable against standard development. We propose a decision rule to determine the optimal expansion timing based on the acquisition of new information on the reservoir and oil price uncertainty. Our results suggest that staged development carries large upside potential for the marginal field development under extensive reservoir uncertainty. In addition, partial hedging against the downside risks in the staged development can enhance the project's economy in a sufficiently significant manner to justify investment.