Abstract

This paper describes a Real Options evaluation of a real-world farmout opportunity in case history format. The Real Options evaluation utilizes exotic options (standard barrier option and cash-or-nothing binary options) borrowed from the financial community and adapted for use in Oil and Gas economic valuations. A Delineate/FO option is constructed to address the question of whether a marginal discovery should be farmed out immediately or be delineated and then farmed out if hurdle reserves are not achieved.

The result of the evaluation is that the marginal discovery should be delineated. The option value associated with the upside reserves potential and the ability to farmout the project should the upside not be realized more than offsets the cost of the option (cost of the delineation program). Hence, delineating and maintaining the option to farmout later enhances total project value. The real options approach to valuing the project is also contrasted with a conventional DCF valuation that gives little insight on the farmout question.

Introduction

Since the mid 1980's Real Options (RO) analysis has made considerable inroads in economic valuations of oil and gas projects. The RO techniques employed range from the Black and Scholes1,2 equation on the simple end of the spectrum to binomial lattice, dynamic-programming techniques on the complex end. Black and Scholes based techniques are attractive because they are easy to implement but often require an oversimplification of the problem at hand. The results often overvalue the project and are not credible due to the oversimplifications required. At the complex end of the spectrum we have binomial lattice, dynamic-programming approaches. These techniques allow one to more realistically match the real world decision making process but are complicated to implement and require specialized knowledge and expertise.

This paper presents a middle ground approach to RO valuations. Through the use of a case study based on a real project valuation, the paper illustrates a process through which one can utilize exotic real options3 to construct valuations that more accurately reflect the real world decisions commonly undertaken in the industry. The case study analyzes a farmout decision for a marginal discovery. The approach presented here is attractive because it is little more complicated than using the Black and Scholes equation. Off-the-shelf solutions to most exotic options are available in the public domain (Ref. 3).

What are exotic options? The financial community has used exotic options for years to value complex option and derivative investment vehicles. Exotic options are often closely tied to the Black and Scholes theory because they often satisfy the same partial differential equation. They differ from the Black and Scholes solution in that they satisfy different boundary conditions. Barriers are a common attribute of most exotic options. The farmout valuation utilizes two types of exotic options, a standard barrier option and a ladder option constructed from cash-or-nothing binary options. These options are discussed in more detail later in the paper.

Case Study Background

An exploratory well and two delineation wells have revealed a marginal oil field. The operator of the field is new to the area and existing oil production is adjacent to the discovered field. The expected reserves based on 3 wells are around 70 mmbo. The field is marginal with a mean NPV12 of around $3 MM. Based on internal hurdle constraints the operator requires at least 130 mmbo to proceed with development. The uncertainty associated with the reserves estimate is large and an upside case with reserves 130 mmbo is within the realm of possibility. The bulk of the uncertainty is associated with the areal extent of the reserves.

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