Abstract

This paper presents a binomial option valuation model, which can be applied to value options in field development projects. The model calculates values of deferral, expansion, and abandonment options. The presented model is applied to a hypothetical test field and two real fields located in the Norwegian Continental Shelf: Brage and Asgard.

The deferral and abandonment options are the most valuable real options if the analysed project is marginal. If the field is very profitable, the expansion option is the most important. In the analysed real cases, the combined option premiums vary from 7 to 43 per cent of the net present value. Excluding the expansion option premiums still range from 1 to 29 per cent.

Option valuation techniques are most useful in analysing projects with significant real options and negative net present values. Option valuation, when used simultaneously with net present value analysis, provides significant additional information to decision makers.

Introduction

There are several uncertainties which influence the value of hydrocarbon extraction projects. First, there are geo-technical uncertainties. Second, hydrocarbon prices may fluctuate considerably during projects which may continue for decades. These uncertainties make it difficult to estimate the value of a hydrocarbon reserve.

The net present value analysis is often applied carelessly omitting many uncertainties from the valuation. It is also often assumed that a project will follow one predetermined course of action throughout its life. Contrary to this common assumption, the management often has several possibilities to improve the project's profitability during the life of the field.

Both the upside potential and managerial flexibilities are important aspects when decisions on asset deals are being made. Consequently, the problem lies in calculating the monetary value of the asset's real potential. Option valuation techniques provide a promising approach for estimating this value.

This paper presents a framework for modelling deferral, expansion, and abandonment options in hydrocarbon extraction projects. The approach is based on two binomial trees. The first values the expansion and abandonment options. The second calculates the combined value of the three options using the results from the first tree. This way option interactions will be taken into consideration.

The underlying uncertainty in the presented option valuation model is the oil price. This uncertainty is modelled using a stochastic price process called the geometric Brownian motion. Uncertainties relating to reserves have been excluded from the model. Another restriction is that the model is limited to pre-tax valuation.

The main input parameters of the model are the risk-free interest rate, inflation, volatility, rate of return shortfall and current oil price. Project specific input parameters include the field's production and cost profiles.

The structure of the paper is as follows: First, the general aspects of real options are discussed. Second, the option valuation model is presented. Third, some properties of the model are illustrated with a hypothetical test case and two real fields. Finally, some conclusions are presented.

Real Options

Real options, i.e. investment opportunities, resemble financial options in many respects. They both can be acquired and exercised in a similar manner. As a stock option, an investment opportunity gives a right, but not an obligation to acquire a certain asset, for example, a developed oil field.

In the presented valuation approach a company has an option to a field's production. By investing to development and by paying production costs, the company can sell hydrocarbons at some future date. On top of the expenditures, the initial oil price, oil price volatility, risk-free interest rate, and timing of the oil sale affect the value of the future production.

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