Valuation of exploration and production assets: an overview of real options models

Abstract

This paper presents a set of selected real options models to evaluate investments in petroleum exploration and production (E&P) under market and technical uncertainties. First are presented some simple examples to develop the intuition about concepts like option value and optimal option exercise, comparing them with the concepts from the traditional net present value (NPV) criteria. Next, the classical model of Paddock, Siegel and Smith is presented, including a discussion on the practical values for the input parameters. The modeling of oil price uncertainty is presented by comparing some alternative stochastic processes. Other E&P applications discussed here are the selection of mutually exclusive alternatives under uncertainty, the wildcat drilling decision, the appraisal investment decisions, and the analysis of option to expand the production through optional wells.