The Value of Flexibility to Expand Production Capacity for Oil Projects: Is it Really Important in Practice?

Abstract

Abstract The selection of the best oil production strategy consists of finding the optimal number of wells and their locations, well flow-rates, well opening schedule, platform production size, water treatment capacity, etc to maximize NPV, RF, among others. But, there is always uncertainty in the determinants of these variables and also there will be risk. An increase in oil price may change the optimal number of wells. Similarly, with an oil price decrease, it may be necessary to shut-in some wells. The problem becomes more complicated because the production strategy must be defined at the early stage of the development. Then, management may find it suitable to pay for some flexibility that could be useful in the future and improve the project profitability. These flexibilities have two benefits. First, they reduce the risk of the NPV of the project. Second, they add value to the entire project. To estimate the value of flexibility in the management of an oil project towards profit maximization, we consider an offshore oil field with 28 °API and 98 million cubic meters of OOIP. Because oil price fluctuates, management finds suitable to start production with 16 wells and a platform with liquid production capacity of 17,700 cubic meters per day. This platform has extra-capacity that can be used in case management needs an increase in oil production, which, is strongly dependent on oil price. This extra-capacity adds value to the project since it allows management, the option to increase production in case of an increase in oil price. To evaluate this flexibility, NPV method is not the right tool, but real options models. We analyze the possibility to exercise the flexibility to increase production by drilling more wells in years 1, 2 or 3 after the opening of 16th well. In this study, we conclude that the value of the flexibility to expand production is not very high. This is unexpected, since in most cases in literature, the value of flexibility is above 25% of the static NPV. The reason, in this case, is due to the high investment in drilling wells and the low impact on the production curve.