Sequential Exploration: Valuation with Geological Dependencies and Uncertain Oil Prices
- Babak Jafarizadeh (Heriot-Watt University) | Reidar Bratvold (University of Stavanger)
- Document ID
- Society of Petroleum Engineers
- SPE Journal
- Publication Date
- October 2020
- Document Type
- Journal Paper
- 2,401 - 2,417
- 2020.Society of Petroleum Engineers
- mean-reverting oil price process, sequential exploration, real options analysis, value of information
- 17 in the last 30 days
- 41 since 2007
- Show more detail
- View rights & permissions
|SPE Member Price:||USD 5.00|
|SPE Non-Member Price:||USD 35.00|
When exploring nearby prospects in a common area, the outcome of drilling a well can change the chance of success in nearby prospects, affecting their economics and drilling decisions. Here, besides possibly discovering hydrocarbons, a single well could also supply information about other wells. For such a cluster of exploration prospects, which well should we drill first, and which next? More importantly, what is the economic value of this group of prospects? The answers are multidimensional; they depend, at least, on geological dependencies and economic dynamics. Because it takes time to interpret each drilling outcome and update our understanding regarding neighboring prospects, the varying hydrocarbon prices also affect the economics of the upcoming wells. Therefore, our sequence of drilling decisions should consider both geological dependencies and uncertainty in prices. In this paper, we develop a valuation model for a group of interdependent prospects. We use a dynamic programming model that combines the binomial representation of prices with the conditional probability of success or failure at each drilling site. The software implementation of the algorithm accompanies this paper and is a useful valuation and decision-support system.
|File Size||1 MB||Number of Pages||17|
Abbas, A. E., Cadenbach, A. H., and Salimi, E. 2017. A Kullback–Leibler View of Maximum Entropy and Maximum Log-Probability Methods. Entropy 19 (5): 232. https://doi.org/10.3390/e19050232.
Bhattacharjya, D., Eidsvik, J., and Mukerji, T. 2010. The Value of Information in Spatial Decision Making. Math Geosci 42 (2): 141–163. https://doi.org/10.1007/s11004-009-9256-y.
Bickel, J. E. 2006. Some Determinants of Corporate Risk Aversion. Decis Anal 3 (4): 233–251. https://doi.org/10.1287/deca.1060.0080.
Bickel, J. E. and Smith, J. E. 2006. Optimal Sequential Exploration: A Binary Learning Model, Decis Anal 3 (1): 16–32. https://doi.org/10.1287/deca.1050.0052.
Bickel, J. E., Smith, J. E., and Meyer, J. L. 2008. Modeling Dependence Among Geologic Risks in Sequential Exploration Decisions. SPE Res Eval & Eng 11 (2): 352–361. SPE-102369-PA. https://doi.org/10.2118/102369-PA.
Brandão, L. E., Dyer, J. S., and Hahn, W. J. 2005. Using Binomial Decision Trees to Solve Real-Option Valuation Problems. Decis Anal 2 (2): 69–88. https://doi.org/10.1287/deca.1050.0040.
Brown, D. B. and Smith, J. E. 2013. Optimal Sequential Exploration: Bandits, Clairvoyants, and Wildcats. Oper Res 61 (3): 644–665. https://doi.org/10.1287/opre.2013.1164.
Cortazar, G. and Schwartz, E. S. 2003. Implementing a Stochastic Model for Oil Futures Prices. Energy Econ 25 (3): 215–238. https://doi.org/10.1016/S0140-9883(02)00096-8.
Cox, J. C., Ingersoll, J. E. Jr., and Ross, S. A. 1985. An Intertemporal General Equilibrium Model of Asset Prices. Econometrica 53 (2): 363–384. https://doi.org/10.2307/1911241.
Cox, J. C., Ross, S. A., and Rubinstein, M. 1979. Option Pricing: A Simplified Approach. J Financ Econ 7 (3): 229–263. https://doi.org/10.1016/0304-405X(79)90015-1.
Cunningham, P. and Begg, S. H. 2008. Using the Value of Information to Determine Optimal Well Order in a Sequential Drilling Program. AAPG Bull. 92 (10): 1393–1402. https://doi.org/10.1306/06040808071.
Dias, M. A. G. and Rocha, K. M. C. 1999. Petroleum Concessions with Extendible Options Using Mean Reversion with Jumps To Model Oil Prices. Paper prepared for presentation at the 3rd International Conference on Real Options, Wassenaar/Leiden, The Netherlands, 6–8 June. http://www.realoptions.org/papers1999/MarcoKatia.pdf.
Dixit, A. 1992. Investment and Hysteresis. J Econ Perspect 6 (1): 107–132. https://doi.org/10.1257/jep.6.1.107.
Dixit, A. K. and Pindyck, R. S. 1994. Investment Under Uncertainty, first edition. Princeton, New Jersey, USA: Princeton University Press.
Eidsvik, J., Martinelli, G., and Bhattacharjya, D. 2018. Sequential Information Gathering Schemes for Spatial Risk and Decision Analysis Applications. Stoch Environ Res Risk Assess 32 (4): 1163–1177. https://doi.org/10.1007/s00477-017-1476-y.
Eidsvik, J., Mukerji, T., and Bhattacharjya, D. 2015. Value of Information in the Earth Sciences: Integrating Spatial Modeling and Decision Analysis, first edition. Cambridge, UK: Cambridge University Press.
Geman, H. 2005. Commodities and Commodity Derivatives: Modeling and Pricing for Agriculturals, Metals and Energy. Chichester, UK: John Wiley & Sons.
Gibson, R. and Schwartz, E. S. 1990. Stochastic Convenience Yield and the Pricing of Oil Contingent Claims. J Finance 45 (3): 959–976. https://doi.org/10.2307/2328801.
Hahn, W. J. and Dyer, J. S. 2008. Discrete Time Modeling of Mean-Reverting Stochastic Processes for Real Option Valuation. Eur J Oper Res 184 (2): 534–548. https://doi.org/10.1016/j.ejor.2006.11.015.
Hahn, W. J. and Dyer, J. S. 2011. A Discrete Time Approach for Modeling Two-Factor Mean-Reverting Stochastic Processes. Decis Anal 8 (3): 220–232. https://doi.org/10.1287/deca.1110.0209.
Hammond, R. K. and Bickel, J. E. 2013. On the Decision Relevance of Stochastic Oil Price Models: A Case Study. Eng Econ 58 (3): 209–230. https://doi.org/10.1080/0013791X.2013.806975.
Jafarizadeh, B. 2019. Discount Rates and Price Forecasts for Upstream Petroleum Valuations. Oral presentation given at the 23rd Annual International Real Options Conference, London, UK, 27–29 June.
Jafarizadeh, B. and Bratvold, R. B. 2012. Two-Factor Oil-Price Model and Real Option Valuation: An Example of Oilfield Abandonment. SPE Econ & Mgmt 4 (3): 158–170. SPE-162862-PA. https://doi.org/10.2118/162862-PA.
Jafarizadeh, B. and Bratvold, R. B. 2013. Sell Spot or Sell Forward? Analysis of Oil-Trading Decisions with the Two-Factor Price Model and Simulation. SPE Econ & Mgmt 5 (3): 80–88. SPE-165581-PA. https://doi.org/10.2118/165581-PA.
Jafarizadeh, B. and Bratvold, R. B. 2015. Oil and Gas Exploration Valuation and the Value of Waiting. Eng Econ 60 (4): 245–262. https://doi.org/10.1080/0013791X.2015.1045647.
Jafarizadeh, B. and Bratvold, R. B. 2019. Exploration Economics: Taking Opportunities and the Risk of Double-Counting Risk. Mineral Economics 32 (3): 323–335. https://doi.org/10.1007/s13563-019-00188-1.
Jaynes, E. T. 1968. Prior Probabilities. IEEE Trans Syst Sci Cybern 4 (3): 227–241. https://doi.org/10.1109/TSSC.1968.300117.
Laughton, D. G. and Jacoby, H. D. 1993. Reversion, Timing Options, and Long-Term Decision-Making. Financ Manage 22 (3): 225–240. https://doi.org/10.2307/3665940.
Lilleborge, M., Hauge, R., and Eidsvik, J. 2016. Information Gathering in Bayesian Networks Applied to Petroleum Prospecting. Math Geosci 48 (3): 233–257. https://doi.org/10.1007/s11004-015-9616-8.
Martinelli, G. and Eidsvik, J. 2014. Dynamic Exploration Designs for Graphical Models Using Clustering with Applications to Petroleum Exploration. Knowl Based Syst 58 (March): 113–126. https://doi.org/10.1016/j.knosys.2013.08.020.
Martinelli, G., Eidsvik, J., and Hauge, R. 2013. Dynamic Decision Making for Graphical Models Applied to Oil Exploration. Eur J Oper Res 230 (3): 688–702. https://doi.org/10.1016/j.ejor.2013.04.057.
Paddock, J. L., Siegel, D. R., and Smith, J. L. 1988. Option Valuation of Claims on Real Assets: The Case of Offshore Petroleum Leases. Q J Econ 103 (3): 479–508. https://doi.org/10.2307/1885541.
Pindyck, R. S. 1999. The Long-Run Evolutions of Energy Prices. Energy J. 20 (2): 1–27. https://doi.org/10.5547/ISSN0195-6574-EJ-Vol20-No2-1.
Schwartz, E. S. 1997. The Stochastic Behavior of Commodity Prices: Implications for Valuation and Hedging. J Finance 52 (3): 923–973. https://doi.org/10.1111/j.1540-6261.1997.tb02721.x.
Schwartz, E. S. 1998. Valuing Long-Term Commodity Assets. Finance Manage 27 (1): 57–66. https://doi.org/10.2307/3666151.
Schwartz, E. S. and Smith, J. E. 2000. Short-Term Variations and Long-Term Dynamics in Commodity Prices. Manage Sci 46 (7): 893–911. https://doi.org/10.1287/mnsc.46.7.893.12034.
Smith, J. E. 2005. Alternative Approaches for Solving Real-Options Problems (Comment on Brandão et al. 2005). Decis Anal 2 (2): 67–123. https://doi.org/10.1287/deca.1050.0041.
Smith, J. E. and McCardle, K. F. 1999. Options in the Real World: Lessons Learned in Evaluating Oil and Gas Investments. Oper Res 47 (1): 1–15. https://doi.org/10.1287/opre.47.1.1.
Smith, J. E. and Nau, R. F. 1995. Valuing Risky Projects: Option Pricing Theory and Decision Analysis. Manage Sci 41 (5): 795–816. https://doi.org/10.1287/mnsc.41.5.795.
van der Hoek, J. 2009. Recombining Binomial Tree Approximations for Diffusions. Handb. Numer. Anal. 15: 361–368. https://doi.org/10.1016/S1570-8659(08)00010-0.