REAL OPTIONS IN PETROLEUMREAL OPTIONS IN PETROLEUMCase Studies in Exploration & ProductionCase Studies in Exploration & Production

By: Marco Antônio Guimarães Dias

Petrobras, Brazil

New Approaches to Value Analysis: New Approaches to Value Analysis: EVAEVA, Real Options and ROV, Real Options and ROV New York, December 13, 1999New York, December 13, 1999

Main Real Options and ExamplesMain Real Options and Examples Option to Delay (Timing Option)

Wait, see, learn before invest Oilfield development; Wildcat drilling

Abandonment Option Managers are not obligated to continue a business

plan if it becomes unprofitable Sequential appraisal program can be abandoned

earlier if information generated is not favorable

Option to Expand the Production Depending of market scenario and the

petroleum reservoir behavior, new wells can be added to the production system

Tract (lease): Option to Explore (wildcat)

Developed Reserves: Options of Expanding, Temporary Stopping , and Abandonment.

Delineated but Undeveloped Reserves: Option to Develop ( to Produce )

Undelineated Field: Option to Appraise

Development Development InvestmentInvestment

Appraisal Appraisal InvestmentInvestment

Wildcat Wildcat InvestmentInvestment

Oil/Gas SuccessProbability = p

Expected Volumeof Reserves = B

RevisedVolume = B’

Options in Exploration & ProductionOptions in Exploration & Production

E&P Process and OptionsE&P Process and Options Drill the wildcat (pioneer)? Wait? Extend? Revelation: additional waiting incentives

Oil/Gas SuccessProbability = p

Expected Volumeof Reserves = B

RevisedVolume = B’ Appraisal phase: delineation of reserves

Technical uncertainty: sequential options

Delineated but Undeveloped Reserves. Develop? “Wait and See” for better conditions? Extend the option?

Developed Reserves. Expand the production?

Stop Temporally? Abandon?

Valuation of Exploratory ProspectValuation of Exploratory Prospect Suppose the case below: how valuable is this prospect?

Suppose that the firm has 5 years option to drill the wildcat Other firm wants to buy the rights of the tract. Do you sell? How valuable is the prospect?

20 MM$(wildcat)

20% success chance

150 MM barrels(expected reserve)

Dry Hole

“Compact Decision-Tree”

Valuation of Exploratory ProspectValuation of Exploratory Prospect The traditional method looks only expected values, forgetting that, in some scenarios (if NPV < 0), rational managers will not exercise the option to develop

the petroleum field. Consider the following data to quantify prospect value:

Petroleum prices: P = 15.1 $/bbl ; Economic quality of a developed reserve: q = 20% (so one barrel of developed reserve = 0.20 x 15.1 = 3.02 $/bbl); Total value of the developed reserve V = q.P.B = 3.02 x B (where B is the number of barrels of reserve); Development cost (D): dividing in fixed (271 MM$) plus variable term (1.1 $/bbl of reserve), hence D = 271 + (1.1 x B)

Using the expected value of reserve volume (B = 150 MM bbl), the value of the prospect by the traditional method is: Net Present Value (NPV) given a discovery: NPV = V D = q.P.B D NPV = (3.02 x 150) (271 + 1.1 x 150) NPV = 17 MM US$ But the chances to discovery petroleum is only of 20% and is necessary to drill the wildcat with cost of E = 20 MM$. So: Expected Monetary Value: EMV = 20 + (20% x 17)

EMV = 16.6 MM US$ (and the prospect is a worthless asset)

Prospect with Option to DevelopProspect with Option to Develop Considering that rational managers will not exercise the

option to develop the petroleum field if it is unprofitable, the prospect value changes a lot. See the table below.

Considering the option, the expected monetary value (EMV) is: EMV = 20 + (20% x 100) EMV = 0

Hence, now we are indifferent to drill the wildcat well.

Prospect Valuation and RevelationProspect Valuation and Revelation The previous option analysis consider only uncertainty in the

reserve size and the option to develop as a “now-or-never” option (option expiring) However is not a “now-or-never” option, it is a 5 years option; In 5 years we shall have many different scenarios due both

uncertainties, market (oil prices, costs) and technical (geology) Revelation of Geology: with the time, the exploratory activity of the

whole industry in the basin will reveal good or bad news about the success probability, the productivity of reserve (so, the economic quality of a reserve q), the size of reserves, etc. In 5 years several wildcats shall be drilled in the same basin, revealing new values

for success chances, reserve productivity and volume, etc. You can wait and see the revelation of information (free information)

If you have an option (not an obligation), in 5 years the option will be exercised only if the scenarios combination is favorable.

Prospect Valuation under UncertaintyProspect Valuation under Uncertainty The table below present the probability distributions at t = 5

years for some uncertain geologic parameters (revelation scenarios) and for one uncertain market parameter (oil prices).

Multiplicative Factor for the Reserve Size Distribution

Parameter Distribution Values

Oil Prices

Economic Quality for the Developed Reserve

Success Probability for the wildcat well

Minimum = 10%Most Likely = 20%Maximum = 30%

Minimum = 0.5Most Likely = 1Maximum = 1.5

Mean = 15.1 US$/bbl

Standard-Deviation = 6 US$/bbl

Exploratory Prospect UncertaintyExploratory Prospect Uncertainty Considering the uncertainties in oil prices, economic quality of reserve, success probability; and reserve

size. Considering probabilistic distributions but keeping the same expected values (assumptions at t = 5 y. not more

optimistic) Without considering the options, the expected monetary value (EMV) @ t = 5 years is negative as before ( 16.6 MMUS$)

Exploratory Prospect and RevelationExploratory Prospect and Revelation However, @ t = 5 years you will exercise the option only if the NPV is positive. So, the unfavorable scenarios will be

pruned (if NPV < 0, set value = zero) Options asymmetry leverage prospect valuation. EMV = + 14.8

Real Options Asymmetry and ValuationReal Options Asymmetry and Valuation

+

=Prospect Valuation

Traditional Value = 16.6

Options Value = + 14.8

Prospect Valuation under UncertaintyProspect Valuation under Uncertainty However, the value with revelation occurs in the future, @

t = 5 years. Discounting this EMV using a discount rate = 10% p.a., we get: Present Value of EMV = PV(EMV) = 9.19 MM$

There is a rent tax to retain the area of concession, but this value is small for exploratory blocks: Rental = US$ 3,000/year; PV(Rental) = 0.01 MM$

Hence, the prospect value with revelation is: Value = 9.18 MM$ > > traditional value ( 16.6 MM$)

In reality, the correct value is even higher, because is possible that the option becomes “deep-in-the-money” before 5 years Depending on both market evolution and partial revelation of geology,

the option can be exercised before t = 5 years

Prospect Valuation under UncertaintyProspect Valuation under Uncertainty Considering the option feature of real assets, we get a very

different result when comparing with the traditional value. Now it is easy to see that higher uncertainty means

higher value if you have time and flexibility (options) Higher geologic uncertainty: non-mature basins

Higher “revelation” potential than mature basins

But in the valuation we consider European option (exercise only @ t = 5 years). This is a lower bound for the true option value.

Considering an American option (option can be exercise earlier), this value is even higher: Correct PV(EMV) > + 9.18 MM $

E&P Process and OptionsE&P Process and Options Drill the wildcat (pioneer)? Wait? Extend? Revelation: additional waiting incentives

Oil/Gas SuccessProbability = p

Expected Volumeof Reserves = B

RevisedVolume = B’ Appraisal phase: delineation of reserves

Technical uncertainty: sequential options

Delineated but Undeveloped Reserves. Develop? “Wait and See” for better conditions? Extend the option?

Developed Reserves. Expand the production?

Stop Temporally? Abandon?

Sequential Options (Dias, 1997)Sequential Options (Dias, 1997)

Traditional method, looking only expected values, undervaluate the prospect (EMV = 5 MM US$): There are sequential options, not sequential obligations; There are uncertainties, not a single scenario.

( Wildcat Investment )

( Developed Reserves Value )

( Appraisal Investment: 3 wells )

( Development Investment )

Note: in million US$“Compact Decision-Tree”

EMV = 15 + [20% x (400 50 300)] EMV = 5 MM$

Sequential Options and UncertaintySequential Options and Uncertainty

Suppose that each appraisal well reveal 2 scenarios (good and bad news)

development option will not be exercised by rational managers

option to continue the appraisal phase will not be exercised by rational managers

Option to Abandon the ProjectOption to Abandon the Project Assume it is a “now or never” option If we get continuous bad news, is

better to stop investment Sequential options turns the EMV to a

positive value The EMV gain is 5 + 3.25 = $ 8.25 being:

(Values in millions)

$ 2.25 stopping development

$ 6 stopping appraisal

$ 8.25 total EMV gain

E&P Process and OptionsE&P Process and Options Drill the pioneer? Wait? Extend? Revelation, option-game: waiting incentives

Oil/Gas SuccessProbability = p

Expected Volumeof Reserves = B

RevisedVolume = B’ Appraisal phase: delineation of reserves

Technical uncertainty: sequential options

Delineated but Undeveloped Reserves Develop? “Wait and See” for better

conditions? Extend the option?

Developed Reserves. Expand the production?

Stop Temporally? Abandon?

The Extendible Maturity FeatureThe Extendible Maturity Feature

T2: Second Expiration

t = 0 to T1:

First Period

T1: First Expiration

T1 to T2:

Second Period

[Develop Now] or [Wait and See]

[Develop Now] or [Extend (pay K)] or [Give-up (Return to Govern)]

T I

M E

Period Available Options

[Develop Now] or [Wait and See]

[Develop Now] or [Give-up (Return to Govern)]

Extendible Options: Dias & Rocha (1998/9)Extendible Options: Dias & Rocha (1998/9) Options with extendible maturities was studied by Longstaff

(1990) for financial applications We (Dias & Rocha, 1998/9) apply the extendible options

framework for petroleum concessions. The extendible feature occurs in Brazil, Europe, USA Base case of 5 years plus 3 years by paying a fee K (taxes and/or

additional exploratory work). Included into model: benefit recovered from the fee K

Part of the extension fee can be used as benefit (reducing the development investment for the second period, D2)

We consider both stochastic processes for oil prices, the traditional geometric Brownian motion and the more realistic mean-reversion process with jumps

Extendible Option Payoff at the First ExpirationExtendible Option Payoff at the First Expiration At the first expiration (T1), the firm can develop the field, or extend the option, or give-up/back to

govern For geometric Brownian motion, the payoff at T1 is:

Nominal Prices for Brent and Similar Oils (1970-1999)Nominal Prices for Brent and Similar Oils (1970-1999) We see oil prices jumps in both directions, depending of the kind of abnormal news:

jumps-up in 1973/4, 1978/9, 1990, 1999; and jumps-down in 1986, 1991, 1997

Jumps-up Jumps-down

Poisson-Gaussian Stochastic ProcessPoisson-Gaussian Stochastic Process We adapt the Merton (1976) jump-diffusion idea for the

oil prices case, considering: Normal news cause only marginal adjustment in oil prices,

modeled with a continuous-time process Abnormal rare news (war, OPEC surprises,...) cause abnormal

adjustment (jumps) in petroleum prices, modeled with a discrete time Poisson process

Differences between our model and Merton model: Continuous time process: mean-reversion instead the geometric

Brownian motion (more logic for oil prices) Uncertainty on the jumps size: two truncated normal distributions

instead the lognormal distribution Extendible American option instead European vanilla Jumps can be systematic instead non-systematic

C++ Software Interface: The Main WindowC++ Software Interface: The Main Window Software solves extendible options for 3 different stochastic processes and two

methods (dynamic programming and contingent claims)

The Options and Payoffs for Both PeriodsThe Options and Payoffs for Both PeriodsT

I M

E

Options Charts

T2: Second Expiration

t = 0 to T1:

First Period

T1: First Expiration

T1 to T2:

Second Period

Period

Real Applications of this ModelReal Applications of this Model A similar stochastic process of mean-reversion with jumps was used

to equity design (US$ 200 millions) for the Project Finance of Marlim field (deepwaters, Brazil)

The extendible options has been used to analyze the development timing of some projects in Campos Basin

The timing policy was object of a public debate in Brazil, with oil companies wanting a higher timing and this model gave some contribution to this debate: We defended a longer timing policy compared with the first version of

the ANP (Brazilian national petroleum agency) In April/99, the notable economist and ex-Minister Delfim Netto

defended a timing policy for petroleum sector citing our paper conclusions about timing policies to support his view! (Folha de São Paulo, a top Brazilian newspaper)

E&P Process and OptionsE&P Process and Options Drill the pioneer? Wait? Extend? Revelation, option-game: waiting incentives

Oil/Gas SuccessProbability = p

Expected Volumeof Reserves = B

RevisedVolume = B’ Appraisal phase: delineation of reserves

Technical uncertainty: sequential options

Developed Reserves. Expand the production?

Stop Temporally? Abandon?

Delineated but Undeveloped Reserves. Develop? “Wait and See” for better conditions? Extend the option?

Option to Expand the ProductionOption to Expand the Production Analyzing a large ultra-deepwater project in Campos Basin,

we faced two problems: Remaining technical uncertainty of reservoirs is still important. In

this specific case, the better way to solve the uncertainty is by looking the production profile instead drilling additional appraisal wells

In the preliminary development plan, some wells presented both reservoir risk and small NPV. Some wells with small positive NPV (not “deep-in-the-money”) and

others even with negative NPVDepending of the initial production information, some wells can be

not necessary Solution: leave these wells as optional wells

Small investment to permit a future integration of these wells, depending of the market evolution and the production profile response

Modelling the Option to ExpandModelling the Option to Expand Define the quantity of wells “deep-in-the-money” to start the

basic investment in development Define the maximum number of optional wells Define the timing (or the accumulated production) that the

reservoir information will be revealed Define the scenarios (or distributions) of marginal production

of each optional well as function of time. Consider the depletion if we wait after learn about reservoir Simplify considering yearly distributions and limiting the expiration of

the option (declining NPV due the depletion) Add market uncertainty (reversion + jumps for oil prices) Combine uncertainties using Monte Carlo simulation Use optimization method to consider the earlier exercise of the

option to drill the wells, and calculate option value Monte Carlo for American options is a frontier research area

ConclusionsConclusions Real Options is the new paradigm for economic analysis of

assets, projects, and opportunities under uncertainty. Real options can be viewed as a NPV maximization given the options

and given the uncertainties/stochastic processes Need training, knowledge, and good computers

Valuation of rights/projects using traditional methods underestimates values, resulting on very wrong values. Implications for petroleum real assets negotiations, bids, etc. Implications for investment decisions and portfolio selection

Firms need to develop simple and more complex models. Simple models are important for fast calculations. Interactive interface, charts, and educational work. Real world and specific issues demand also more complex and

“taylor-made” models: in-house models Firms need to follow the state of the art and the growing literature