REAL OPTIONS ANALYSIS OF MARGINAL OILFIELD DEVELOPMENT PROJECTS: THE CASE OF THE UKCS By: Theophilus Acheampong MSc (Econ) in International Business, Energy & Petroleum December, 2010
Nov 22, 2014
REAL OPTIONS ANALYSIS OF MARGINAL OILFIELD DEVELOPMENT PROJECTS: THE CASE OF THE UKCS
By: Theophilus Acheampong
MSc (Econ) in International Business, Energy & Petroleum
December, 2010
Origins: Management flexibility
Understanding the concept─ The Real Options Approach to Investment─ Real Options and Total Value─ E&P as a Sequential Real Options Process
Case Study─ Assumptions─ Methodology─ Results
Summary and Conclusions
Appendix
OVERVIEW
Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum
University of Aberdeen, Aberdeen, U.K.
Origins: Management flexibility Many oilfield development projects are not static, they involve varying degrees of
risks and uncertainties. There are:― Geo-technical Risks e.g. Petroleum Reserves Risks― Market & Macroeconomic Risks (e.g. oil prices, inflation and discount rates)
How does management remain flexible in the midst of these uncertainties?
A modular development plan based on these unexpected events is what is needed.
Management can modular these development projects for example by waiting, expanding, contracting and abandoning.
This flexibility has value and capturing this value is what Real Options Analysis (ROA) entails
Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum
University of Aberdeen, Aberdeen, U.K.
Understanding The Concept 1: The Real Options Approach to Investment
ROA is a modern methodology for economic evaluation of projects and investment decisions under uncertainty It complements (not substitutes) the corporate tools as yet.
ROA can be viewed as an optimization problem: Maximize the NPV (the objective function) subject to:
― Market uncertainties (eg.: oil price);― Technical uncertainties (eg., oil in place volume); and― Relevant Options (managerial flexibilities)
ROA considers the uncertainties and the options thus answeing 2 questions: What is the value of the investment opportunity (value of the option)?; and What is the optimal decision rule (threshold)?
ROA is the Application of Financial Option Valuation Techniques to Business Assets
Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum
University of Aberdeen, Aberdeen, U.K.
Understanding The Concept 2 : The “Total Value” Approach
Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum
University of Aberdeen, Aberdeen, U.K.
Understanding The Concept 3: Decision Tree Analysis & Real Options
Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum
University of Aberdeen, Aberdeen, U.K.
Com
mit
Now
Wait and See
High Probability, λ
Low Probability, (1-λ)
Preserve Field
Develop Field
Oilfield Investment
High Probability, λ
Low Probability, (1-λ)
Preserve Field
Preserve Field
Develop Field
Develop Field
Work Backwards
Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum
University of Aberdeen, Aberdeen, U.K.
Understanding The Concept 4 : (E&P as a Sequential Real Options Process)
Case Study 1
Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum
University of Aberdeen, Aberdeen, U.K.
The project was aimed at:― Making an analysis of the DCF valuation methodologies vis-à-vis ROA― The ROA looked at the flexibility value of Deferral, Abandonment, and
Expansion Options during the relinquishment requirement period
A sample undeveloped marginal oilfield in the UKCS was utilized for this study
Marginal oilfields may prove uneconomic when developed under current circumstances.
This was chosen to highlight the significance of risks to the valuation method employed and the strategic importance of these options
The methodology for the study comprised of capital budgeting using the DCF via the Net Present Value(NPV)
For the ROA via the option pricing models (i.e. Black-Scholes and Binomial Lattice Models).
Case Study 2: Methodology
Abandonment Option Model
Deferral Option Model
Expansion Option Model
Key Input Data Base NPV ModelOption Valuation
Parameters
Fig 1: Valuation Methodology Summary
Key Input Data
• Revenues - Oil prices and Production volumes
• Costs - Tariffs, Development and Operating expenditures
• Other data - such as the UK Fiscal Terms and Discount Rate (Cost of Capital)
DCF Base Model
• Cash Flows – Pre and Post Tax Basis
• Base NPV, IRR, Payback Period Profitability Index
• DCF Sensitivity Analysis – e.g. Monte Carlo Simulation
Option Valuation Parameters
• Identify and model project uncertainties
• Estimate project volatilities using MC Simulation
• Calculate the other 5 determinants of the option value (e.g. strike price)
• Estimate option values using opting pricing methods (e.g. Binomial Lattice)
Embedded Project Options
• Deferral Option Base Value and Sensitivity Analysis
• Expansion Option Base Value and Sensitivity Analysis
• Abandonment Option Base Value and Sensitivity Analysis
Case Study 3: Main Results
Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum
University of Aberdeen, Aberdeen, U.K.
PROJECT PROFITABILITY METRICSBase Case NPV NPV $M 262.30
IRR 65.7%Profitability Index 1.23
Real Options Analysis Values (Expanded NPV)
Deferral Option $M 317.21Expansion Option $M 270.13Abandonment Option $M 262.31
Deferral OptionExpansion Option
Abandonment Option
-
50
100
150
200
250
300
350
400
317.21
270.13 262.31
262.30 262.30
262.30
Real Options Analyis Value Static NPV
Valu
es
($ m
illio
n)Note: Expanded NPV = Base NPV + Option Value
Project Values with Flexibility (Base Case Scenario)
Summary & Conclusions
Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum
University of Aberdeen, Aberdeen, U.K.
Real Options Analysis is an important step beyond DCF.
It is a powerful tool in project evaluation as it views projects as options to react to unfolding uncertainties.
ROA allows to us calculate the value of future flexibility. The total value of an investment is an important key stone for strategic decisions.
The results indicate that the value of the oilfield can be significantly improved by considering the flexibilities indicated by the embedded options
For example, using the options approach by incorporating a Deferment Option, the project value is 20.5% greater the static DCF value.
ROA presents advantages over the DCF valuation because: It creates the opportunity to maximize the upside potential and lower the
downside risks.
It accurately accounts for the project value
Thank You:
Questions?
Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum
University of Aberdeen, Aberdeen, U.K.
APPENDIX
Classical Model of Real Options in Petroleum
Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum
University of Aberdeen, Aberdeen, U.K.
Paddock & Siegel & Smith (1987-88) wrote a series of papers on valuation of offshore reserves.
It is the best known model for oilfields development decisions It explores the analogy financial options with real options
Option CalculationSimulation Continuous Discrete
Monte Carlo Simulation Black/Scholes & Derivatives Binomial Trees
+ Easy to understand
+ Applicable to all Real Options constructs
+ Mathematically elegant
+ Relatively easy to calculate manually
+ Easy to understand+ Applicable to all Real Options
constructs+ Simple Real Options
modelling+ Fast calculation
− Very laborious implementation
− Slow calculation− Delicate issues in valuation
of Real Options (correlations, probabilities) etc)
− Complex to very complex
− Hard to understand for practitioners− Limited applicability
− Very laborious implementation with Excel
− Interpretation of results not very intuitive
Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum
University of Aberdeen, Aberdeen, U.K.
Spreadsheet Samples: NPV Analysis
Spreadsheet Samples: Deferral Option Analysis
Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum
University of Aberdeen, Aberdeen, U.K.
Some Important Scientific Foundations of Real Options