Abstract
Investments in oil and gas are subjected to increasingly sophisticated financial analyses. Real option valuation is prominent among the new financial analytical tools being applied prospectively to projects in the industry. This paper begins with the observation that many real option analyses are formally, technically correct and yet clearly lack substantial influence on decisions and ongoing project management. The paper considers possible explanations for this lack of influence, including aspects of model design and construction, organizational structure, training, and corporate communication habits. The paper explores two problems in more detail. First, the mathematically powerful assumption of optimal exercise is built into all real-option models, yet it clearly over-simplifies corporate behavior. The paper cites recent advances in corporate finance theory to show why corporations sometimes fail to exercise options optimally. These include insights from research on agency costs, information asymmetries, and corporate governance. When these problems acquire first-order significance they tend to undermine the credibility of an otherwise sound model. Second, there is a dissonance between the established language of capital budgeting (essentially cash flows and discount rates) and the language of real options, which is still evolving, but which must at a minimum accommodate changes over time in key variables and the phenomenon of active rather than passive management. The paper concludes with practical suggestions for surmounting or skirting these obstacles, drawn from the author's experience as an academic and consultant in the field of real option valuation.
