Two-Factor Oil-Price Model and Real Option Valuation: An Example of Oilfield Abandonment

Abstract

We discuss the two-factor oil-price model in valuation and analysis of flexible investment decisions. In particular, we will discuss the real options formulation of a typical oilfield-abandonment problem and will apply the least-squares Monte Carlo (LSM) simulation approach for calculation of project value. In this framework, the two-factor oil-price model will go a long way in the analysis of decisions and value creation. We also propose an implied method for estimation of parameters and state variables of the two-factor price process. The method is based on implied volatility of option on futures, the shape of the forward curve, and the implicit relationship between model parameters.