Uncertainty resolution in recovery driving factors is a crucial issue in oil and gas exploration and exploitation activities. One such application is to select field candidates for development in the midst of several stochastic variables e.g. recoverable reserves, production rates, gas/oil price, discount rates etc. Unfortunately, the cashflows from investments tend to be stretched out in several years. Traditionally, to measure such inherent potential risks, engineering analysis is performed along with project economics. Engineering analysis builds confidence around recovery factors whereas the economic analysis justifies the returns through NPV and IRR computation. One implicit yet critical behavior, however, is often neglected. Investments tend to have embedded flexibilities, i.e. they are not always now or never type, which can be valued as flexible decisions via the theories available for financial options mathematics1,2. This paper investigates the application of financial mathematics to determine viability of a tight gas reservoir as an investment candidate and presents some interesting results dictated by intrinsic optionality.

Real options (RO) have gained increasing popularity in the oil and gas community in the recent past3–6. These applications employ analytic solutions of Black-Scholes type partial differential equation (PDE) available in the literature7–9 which are usually limited to cases of relatively simple payoff structure, exercise strategy, lower dimensions etc. However, most realistic cases, at the very least, will have complex payoff structure e.g. cascading cashflows in the example considered in this paper. Moreover, these options can be exercised anytime during the life of the project i.e. American type options. To accurately and rigorously compute option values in such cases one has to resort to suitable numerical approach to solve the PDE along with appropriate, complex boundary conditions.

In this paper, we prescribe one such technique, namely Implicit Mulitgrid Finite Difference (IMFD) to asses a two well pilot development program. Based on a previous engineering study, stochastic driving factors for the investment are determined. The investment is then crafted in a RO framework. Representative PDE is solved with imposed boundary conditions. Two different scenarios are considered and results discussed. Finally, exercise boundaries are forecasted above which, at a given time in the course of the project life, it is beneficial to exercise the option (in this example drill the development well) instead of waiting for a future exercise.

Background and Motivation

Traditional Discounted Cashflow (DCF) approach suffers from one significant drawback, namely it assumes single decision pathway with fixed outcomes. On the other hand, in practicality decisions are actuated in the midst of uncertainty resolution and knowledge gained by management. This consequence of high uncertainty coupled with management's flexibility to make midcourse strategy corrections as more information is made available is the essence captured in the real options approach10,11. Management always acts rationally and with judgment whereas DCF based economic valuation methodology never accounts for this way of action. Occasionally, DCF results are further refined by scenario analysis, Tornado diagrams and Monte Carlo simulations of sensitive variables. Nevertheless, none can capture the value of flexibility and knowledge. This additional knowledge gained ultimately resolves uncertainty around key variables which, in turn aids rational decision making. This age old, inherent disconnect between theory and practice has motivated researchers to borrow ideas from financial options and reconstruct a new framework to value projects through real options12. Although slow to gain widespread popularity, the prevalent literature suggests that there are numerous business instances where real options can deduce a much higher value compared to static NPV calculations10. It must be mentioned, however, that the projects which are deep-in-the-money (positive NPV) or deep-out-of-the-money (highly negative NPV) are easier to decide on and should never be considered for further real options analysis. It is the near-money (swing) projects that could benefit from the insights gained from real options analysis.

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