Traditional investment analysis, which accepts investments when the discounted values of their expected future cash flows are positive and otherwise rejects them, is generally incorrect because of its inability to adequately account for the uncertainty of future oil prices and the capacity of managers to take actions in the face of those changing prices. Oil companies often attempt to deal with this problem through the application of techniques ranging from price sensitivity analysis to complex decision analysis or dynamic programming techniques with varying degrees of success. The objective is to value the investment managed, in some sense, optimally over time, as the future environment is revealed. Such techniques may address the shortcomings of more simplified approaches, but are at best extremely cumbersome and at worst impossible to perform correctly. This paper illustrates the shortcomings of the traditional approach to investment analysis as well as a particularly sophisticated variant, dynamic programming, and offers option pricing as an alternative analytic technique.

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