Least-Squares Monte Carlo simulation (LSM) is a promising new technique for valuing real options that has received little or no attention in the oil and gas industry. In this paper, we will demonstrate how LSM can handle more realistic valuation situations including the ability to (i) handle more realistic (probabilistic) price models and (ii) deal with multiple, possibly correlated, uncertain variables.
The LSM method is applied here to an economics problem faced by many operators: What is the value of a gas field given the decision to trade the gas on the spot market as opposed to selling the gas through a long-term supply contract? A company that chooses to trade gas can decide when and how much to produce and can profit from changing market conditions, as by increasing production during a high-price environment.
Three uncertainties have been modeled: the gas price, the operational costs, and the rate of production decline. Increasing profitability associated with rising hydrocarbon prices is typically partially offset by increasing expenditures. Hence the costs have been correlated with the gas price. The expectation of the remaining reserves is continuously adjusted on the basis of the performance of the field. The latter is simulated by stochastically modeling the rate of production decline.
The paper shows that a gas field that can be produced and abandoned at will has large value of flexibility. The Net Present Value of such an asset will underestimate the true economic value. A further benefit of using the real option valuation approach discussed here is that the valuation procedure produces a strategy map showing actions within the project, not just numbers.
Flexibility is an important part of a firm's action but is not well modeled by traditional financial tools. Creating an effective strategy typically has two critical, but in some ways conflicting, objectives: making the most of what a company is, and preparing for what it can be (Marcus 2005). Preparing for the unknown future involves adapting to that future as it unfolds. The petroleum manager's toolkit contains many qualitative descriptions of this adaptation, all of which implicitly follow an "if/then/else" structure. For example, a petroleum manager might want to consider the value of an exploration license. Using words, she will argue that if the appraisal and exploration show significant potential of reserves, then the company should apply for a production license; otherwise (else) the company should refrain from doing so, because a license will not be profitable. The traditional discounted cash flow (DCF) approach cannot reflect this if/then/else structure, but real option valuation (ROV) can.
How managers cope with uncertainty is in stark contrast with how they typically model and value it. DCF is based on the unrealistic assumption that once an initial investment is made, the project will run its course without intervention. The possibility of abandoning a project in the face of adverse circumstances or expanding it in response to unanticipated demand is not considered.