Abstract

This case study is on a satellite close to a large gas and condensate field in the North Sea. At present one well has been drilled. The discovery well will be recompleted as a producer and one or two more producers are envisaged. These could be drilled straightaway or scheduled sequentially, in which case a revision of the project will be carried out. This paper presents a new way of sequentially updating the technical parameters (e.g. size of reserves, productivity of wells, etc) in response to new well information and incorporates this into a real option evaluation of the whole project.

The production scenario is that the project is stopped as soon as the costs exceed the revenue. Two different models (Black and Scholes and a mean reverting model) have been used to describe fluctuations in the oil price on which the gas price is indexed. Monte Carlo simulations have been used to evaluate the three development options (1 or 2 extra wells, drilled immediately or sequentially) for both price models.

Introduction

Real options provide a very promising way of valuing projects ranging from mines1 and oil fields2,3,4,5 to R&D programs6, and even real estate7,8. The idea behind this approach is that traditional project evaluation techniques such as DCF fail to capture all of a project's value because they fail to take account of management's ability to react to changing circumstances. For example, owning an offshore lease gives the company the right to develop the field straight away, or to defer development until additional information becomes available. This could be of a political nature such as the results of a forthcoming election, or could be technical such as the results of drilling an extra well on the property or on an adjoining lease.

The first step in applying option pricing is to identify the options embedded in a project. In the early 90s, Markland8 noted that despite the prevailing enthusiasm for option pricing and real options, "the literature contains little with respect to ‘real’ operating options and prefers to concentrate on financial options". At that time applications of real options to the oil industry focussed primarily on stop/start options such as

  • To invest in a project

  • To abandon a project

  • To mothball it temporarily

  • To defer or accelerate production

Valuing these options only requires models for oil prices which are available in financial literature. The other main source of uncertainty in oil projects is the reserves. One of the main aims of this paper is to study the impact of additional wells on project value. In a study of an exploration prospect Kemna10 alludes to this question but does not tackle it. He considered three options:

  • giving up the lease,

  • developing the project or

  • drilling an additional well each year in order to retain the lease.

To simplify the computations, he "assumed that these holes do not provide new information for the estimation of the size of the reserve. Consequently the only potential benefit from drilling the holes is postponing the investment for a couple of years." Over the past decade several authors have proposed ways of valuing information as it becomes available.

Dias11 developed a game-theoretic approach based on the Brazilian experience after Petrobras's monopoly ended. Companies obtain short leases (typically 5 years) over tracts where seismic data is available but no wells. Information on the basin can be obtained directly by drilling a wildcat well; alternatively the company can wait and see the results of drilling on adjoining tracts.

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