Steam-assisted gravity drainage (SAGD) projects are characterized by long project lives, moderate profit margins and large upfront capital costs. Project capital costs are further increased when an upgrading facility is built to convert bitumen into synthetic crude oil before it is sent to a refinery. These projects are exposed to multiple sources of uncertainty, such as the light/heavy differential, the synthetic crude oil price, and the natural gas price, which can have an important influence on the design and value of the project. Indeed, an important reason for building an upgrading facility is its ability to reduce net cash flow uncertainty in addition to any gains in profit margin that it may produce.

Currently, the design and value of SAGD projects are determined using discounted cash flow (DCF) methods. The effectiveness of these methods is limited by their inability to differentiate project designs based on net cash flow uncertainty associated with each design. We use the real option (RO) valuation method to demonstrate in an accessible manner that a reduction in net cash flow uncertainty may be a compelling economic reason for building an upgrading facility. We further show that using the DCF method may produce valuation results that are unfairly biased against the upgrading option since the DCF method has difficulty accounting for variations in project uncertainty. The implications of this difference between DCF and RO valuation methods for engineering design are also discussed.


Albertan crude oil production currently accounts for 66% of total Canadian oil production. Bitumen production from oil sands currently accounts for 30% of total Albertan oil production. The Alberta Department of Energy suggests that by 2020, oil sands production could increase from the current level of about 1.0 million b/d to 3.0 million b/d. To achieve this production level, forecasts indicate that over $80 billion will be invested between 2003 and 2020. Ultimate potential reserves are estimated to be 315 billion barrels. Of the remaining oil sands reserves, about 85% are too deep to be mined, requiring insitu extraction methods such as SAGD. Clearly, insitu operations such as SAGD will dominate future oil production activities in Alberta, providing significant economic benefit to the province and it's people.

An overview of the Discounted Cash Flow and Real Option valuation methods

Modern finance and valuation theory provides two methods for calculating project net present value (NPV). One method is discounted cash flow (DCF) which has wide acceptance and an extended history in the petroleum industry. The other method is real options (RO) which is relatively new and is slowly gaining acceptance for its more detailed description of project risk and management's ability to manage it.

These NPV calculation methods share the same theoretical foundation and limitations but are differentiated by their approach to adjusting project cash flows for risk. The DCF method uses an aggregate risk-adjustment method in which adjustments for both risk and time are applied to the net cash flow stream.

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