The Value of a Seismic Option

Abstract

Abstract Exploration and production agreements worldwide typically include seismic surveys and exploratory drilling obligations as key contractual provisions. In some jurisdictions, most notably the United States, agreements typically do not include drilling obligations. The lessee holds a right rather than an obligation to drill and, therefore, may relinquish acreage without drilling if the results of seismic surveys or other geological tests prove unfavorable. It is often possible in other jurisdictions to negotiate such a "seismic option" in exchange for less favorable treatment with respect to other contractual provisions such as profit share. An implicit option may also exist to the extent that a reduction in exploratory well commitments can be obtained by offering additional seismic work. In the case of such trade-offs, the ability to quantify the value of the seismic option is a necessity. This paper presents a framework for this valuation. Introduction The value of a seismic option stems from information a seismic survey may provide about two components critical to the drilling decision. The first component is information about prospect reserve size distribution. The second is information seismic provide about the probability of hydrocarbon accumulation, commonly referred to as the chance factor. Initially, we will focus upon the prospect reserve size component and then return to chance factor at the end of this discussion. Prospect Reserve Size A good starting point for understanding the prospect reserve size component of seismic option value is to note the relationship to an analog that has been exhaustively studied — financial options. The most basic financial option is the European call option, which represents the right, but not the obligation, to exchange cash for an asset at some prespecified price and maturity date. A typical asset is a publicly traded commodity for which market price at any time is easily discoverable. The prespecified price is commonly referred to as the "strike" or "exercise" price. The European call option has a value in excess of a corresponding forward commitment to buy at the prespecified price (through, for example, a futures contract) because of the asymmetry in the pay-off. Thc option is only exercised in cases where the market price for the underlying asset exceeds the strike price at maturity. Figure 1 illustrates the pay-off for a European call option as a function of the market price for the underlying asset. The value of a financial option is critically dependent upon the probability distribution for prices at the maturity date. This probability distribution can be described from consideration of both the structure and market parameters underlying stochastic price movements. The most widely employed model for pricing European options, developed in 1973 by Black and Scholes, assumes that prices follow a geometric Brownian motion process. This assumption implies a lognormal distribution with mean equal to the forward price of the asset at maturity and a variance that is a function of the time to maturity and volatility of the price process. This latter parameter can be reasonably estimated from the most recent history of price movements. Figure 2 illustrates lognormal distributions of price for various combinations of maturity and volatility on an asset with a $50 forward price. P. 25^