REAL OPTION

An Alternative Approach of Oil & Gas

Investment Valuation

BENNY LUBIANTARA

Presented in IATMI Conference ,2000

Background

Objectives

Investment Valuation Using DCF

Method

DCF Method in Practice

Introduction to Option Pricing Theory

What is Real Option

Real Option for Investment Valuation

Application : Simple Case Study

Summary

What Next ?

PRESENTATION BACKGROUND

VALUATION

MODELS

DCF

Models Relative

Valuation

Models

Option

Pricing

Models

“Real

Options”

Model

Objectives :

To demonstrate how financial option

pricing theory can be applied to

evaluate investment in oil and gas

business.

To demonstrate the Difference from

traditional Discounted Cash Flow

(DCF) Method.

Investment Valuation

using DCF Method :

NPV

IRR

Payback Period

Profitability Index

INVESTMENT CRITERIA :

DCF METHOD

(In Practice)

Sensitivity Analysis

Scenario Analysis

Simulation Analysis

Decision Tree

Influence Diagram

Multiple Discount Rate

Weighted Average Discount Rate

(WADR)

Modify DCF Traditional Method Using :

Oil prices are very unpredictable, it is not

easy task to estimate future cash flow.

Does not take into account the flexibility

available in a typical project

Difficult to estimate an appropriate discount

rate which reflects the risks of the cash flow.

Traditional DCF miss flexibility ?

Invest Accept

Outcome

LearnInvest Modify Outcome

DCF :

In Reality :

Introduction to

Option Pricing Theory

What is an Option ?

An option is a contract which gives

its holder the right, but not the

obligation, to buy (or sell) an asset

at some predetermined price within

a specified period of time.

A put option gives the buyer the right to sell

the underlying asset at the strike price.

Introduction to

Option Pricing Theory

Type of Options :

A call option gives the buyer the right to buy the

underlying asset at a fixed price - the strike or

exercise price (X) at some time before the

expiration date of the option.

American option : An option that can be

exercised at any time on or before the

maturity date.

Introduction to

Option Pricing Theory

European option : It gives a holder the

right to buy (or sell) a particular stock at a

specified price at maturity date.

Determinants of Option Values

Variable relating to financial markets

r, risk-free interest rate

Variables relating to stock

stock price

dividends paid

stock price variance

Variables relating to option characteristics

strike price

European or American option

time to expiration

OPTION VALUATION

Based on idea of replicating portfolio, i.e., a

portfolio composed of the underlying asset and

a riskless asset which generates the same

cash flow as the option

Two General Approaches

Binomial

Black-Scholes

BINOMIAL MODEL

Consider an asset movement following a

binomial process, and a call option on the asset.

S

C

uS

Cu=max(uS-K,0)

dS

Cd=max(dS-K,0)

p

1-p

OPTION VALUATION

OPTION VALUATION

The call option price can be written as :

Which is :

))1(( du

rt CppCeC

du

dep

rt

OPTION VALUATION

))1(( ,11,1, jiji

rt

ji cppcec

General Formula for Binomial Model :

OPTION VALUATION

BLACK-SCHOLES FORMULA

dzdtS

dS

Assumption : Stock follow the stochastic process,

called Geometric Brownian Motion (GBM) :

dtdz ~

, are constants

dt: percent average return on the asset during a small

interval

: volatility of the asset

dz Wiener process

= random drawing from a standardized normal distribution

OPTION VALUATION

B-S Differential Equation :

02

12

222 rc

s

cs

s

crs

t

c

Additional Assumptions :

No dividends during the option’s life.

No transactions costs.

rf is known and constant during the option’s life.

Option can be exercised only on its expiration date.

OPTION VALUATION

B-S Formula :

Where :

)2

N(rte)1

N( SC dXd

t

/2)t(rLN(S/X)

1

2

d

t12

dd

Notation :

S, Current Stock price

X, Exercise Price

t, Time to Expiration

, Volatility of the return of the stock

r, Risk Free Interest Rate

N(d), Cum.Probability Distribution Function

WHAT IS REAL OPTION ?

Real Option is the analogy from the

financial option for real asset (non

financial asset).

An Option on a non traded asset, such as

an investment project, oil and gas

reserve, gold mine, etc.

COMMON REAL OPTIONS

Option to Defer (“wait and learn”)The firm can wait several years to see if market condition

justify constructing the plant or developing the field.

Option to ExpandIf market and technical condition are more favorable than

expected, the firm can expand the scale of production.

Option to AbandonIf market condition decline severely, the firm can abandon

the operation and realize the resale value of capital

equipment or other assets on the second hand market.

Options in Oil and Gas E&P :

•Develop ?

•“Wait and See” for Better Condition ?

Developed Reserve

• Expand ? Stop Temporarily ? Abandon ?

CALL OPTION UNDEVELOPED RESERVES

S Current Stock Price Current Value of Developed Reserve

Volatility of Rate of

Return on the Stock

Volatility of Rate of Change of the

Value of a Developed Reserve

X Exercise Price Development Cost

T Time to Expiration Relinquishment Requirement

r Risk Free Rate of

Interest

Risk Free Rate of Interest

Analogy

Financial Option - Oil Reserves

REAL OPTION

for Investment Valuation

Simulation

Analysis

- Analytical Solution

(B-S Formula)

- Numerical Solution

- Binomial Model

- Trinomial Model - Monte Carlo

Partial Differential

EquationDynamic

Programming

Solutions

Options Identification Stage

Mathematical Modeling

Application :

Simple Case Study : 1 Offshore deepwater oilfield “XYZ” has estimated oil

reserves : 1 MMBO

Development cost = US$ 18/barrel

Current oil price = US$ 15/barrel

t= 10 years

Volatility = 5%

Risk Free interest rate = 8%

Using B-S formula, we will obtain the value : US$ 691,210

According to BS-calculation, this oil reserves, even

though not viable at current price, still is a valuable

property because of its potential to create value if oil

prices go up.

This is not captured by traditional DCF method.

Simple Case Study : 2

-

10,000

20,000

30,000

40,000

50,000

60,000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19

PRODUCTION FORECAST "BL-1" FIELD

DATA :

Development cost 2,500,000$

Yearly operation costs 100,000$

Current oil price $16/bbl

Volatility 25%

Risk free interest rate / Rf 5%

Relinquishment period 20 years

Depreciation 5 years

Simple Case Study : 2

If we consider only option to defer, the calculation for both DCF and real option

as follows :

It is better to wait until the oil price reach $18.5 per barrel to start developing

the project, below that price, the option value is worth more than “now or

never” decision (as calculated using DCF method).

Value of Field "BL-1"

(4)

(3)

(2)

(1)

-

1

2

3

4

5

6

5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35

Price

Mill

ions

DCF

OPM

SUMMARY

Real Options is the new paradigm for

economics analysis of asset, projects

and opportunities.

This technique is most useful when the

analyzed projects have significant

options and the future is uncertain.