An Integration Of Real Options And Utility Theory For Evaluation And Strategic Decision-making In Oil Development And Production Projects

The results from the Discounted Cash Flow (DCF) are limited as a tool for decision-making in the petroleum industry because they don't properly take into account four important features of the modern investments: uncertainty, irreversibility, timing, and corporation's risk-aversion. Recent developments in real options and preference theories have allowed decision-makers to employ these two approaches separately in the process of valuation and decision-making of risky projects. This paper presents a model for valuation and decision-making integrating discounted cash flow, real options and preference theory and aims at answering the following questions: i) What is the current value of an oil project? ii) What is the optimal working interest in this project venture? iii) What are the criteria to select projects considering investment irreversibility, uncertainty and timing to implement decisions? This model is applied to valuation and decision-making of a project to produce oil from a deep-water reservoir and its results are compared to those of the traditional approach. Traditional model suggests that, as the project value is above its investment cost, the corporation should invest immediately and incur in 100% working interest. Contrarily, for an specific analysis, the integrated model suggest the corporation should invest as long as project current value is as large as 1.85 times investment cost and should take only 44.38% working interest, whereas partners fund and acquire the remaining 55.62% of the project. In general, results indicate that NPV tends to pay more attention on return and does not account properly for risk. Then, as the uncertainty (volatility) of strategic variables increase, the two models give more divergent results. Copyright 2005, Society of Petroleum Engineers Inc.227239Dixit, A.K., Pindyck, R.S., (1994) Investment under Uncertainty, , New Jersey: New Jersey University PressLima, G.A.C., Suslick, S.B., Impacts of environmental constraints on the optimal decision-making process applied to Brazilian petroleum industry (2002) Journal of Canadian Petroleum Technology, 41, pp. 37-43Black, F., Scholes, M., The pricing of options and corporate liabilities (1973) Journal of Political Economy, 81, pp. 637-659McDonald, R., Siegel, D., The value of waiting to invest (1986) Quartely Journal of Economics, 4 (101), pp. 707-727Wilkerson, J.P., (1988) A Case History Application of Risk Preference Techniques to Evaluate Petroleum Exploration Prospects, , PhD. Dissertation, University of Texas, AustinLima, G.A.C., (2004) Using Real Options and Preference Theory in Projects of Production and Exploration of Petroleum, , PhD. Dissertation, State University of Campinas, CampinasTrigeorgis, L., (1996) Real Options - Managerial Flexibility and Strategy in Resources Allocation, , Cambridge: MIT Press, third editionLerche, I., Mackay, J., (1999) Economic Risk in Hydrocarbon Exploration, , San Diego: Academic PressCopeland, T., Antikarov, V., (2001) Real Options: A Practitioner's Guide, , Texere LLC (New York, NY)Brealey, R.A., Myers, S.C., (1992) Corporate Finance. Fourth Edition, , New York: McGraw-HillVon Neumann, J., Morgenstern, O., (1953) Theory of Games and Economic Behavior, , Princeton University Press, Princeton, New Jersey, 3rd EditionLuenberger, D., (1998) Investment Science, , Oxford University PressNewendorp, P.D., (1975) Petroleum Explorations and Decisions Analysis, , PenWell BooksCampbell Jr., J.M., Campbell Sr., J.M., Campbell, R.A., (2001) Analyzing and Managing Risky Investments, , John M. CampbellCozzolino, J., (1980) Controlling Risk in Capital Budgeting: A Practical Use of Utility Theory for Measurement and Control Petroleum Exploration Risk, 25 (3). , Engineering Economist: American Society for Engineering Education & American Institute of Industrial EngineersNepomuceno, F., Suslick, S.B., Walls, M., Managing technological and financial uncertainty: A decision science approach for strategic drilling decision (1999) Natural Resources Research, 8 (3), pp. 193-203Walls, M., Corporate risk tolerance and capital allocation: A practical approach to implementing an exploration risk policy (1995) Journal of Petroleum Technology, 47 (4), pp. 307-311Walls, M., Dyer, J., Corporate risk propensity and firms performance: A study of petroleum exploration industry (1996) Management Science, 42 (7), pp. 1004-102