A Step-by-Step Approach to Improving Investment Decisions and Asset Valuation Real Options in Exploration

1
A Step-by-Step Approach to Improving Investment
Decisions and Asset ValuationReal Options in
Exploration Production of Petroleum
Real Option Valuation? (ROV?) ConferenceMaximize
Return Minimize Risk in Strategic
InvestmentsNew Orleans, March 21, 2000

• By Marco Antônio Guimarães Dias
• Petrobras, Brazil

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Main Real Options and Examples

• Option to Delay (Timing Option)
• Wait, see, learn before invest
• Oilfield development Wildcat drilling
• Abandonment Option
• Managers are not obligated to continue a
  business plan if it becomes unprofitable
• Sequential appraisal program can be abandoned
  earlier if information generated is not favorable
  
• Option to Expand the Production
• Depending of market scenario and the petroleum
  reservoir behavior, new wells can be added to the
  production system

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Options in Exploration Production (EP)
Oil/Gas Success Probability p
Expected Volume of Reserves B
Revised Volume B
Development Investment
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Types of Uncertainties in EP

• Exploration Production of petroleum is subject
  to all types of uncertainties. For investment
  decisions and valuation purposes, the main types
  of uncertainty are
• Technical Uncertainty about the existence, the
  size, and the economic quality of the reserves.
• EP technology in ultra deppwaters is another
  example.
• This uncertainty is solved by a step-by-step
  investment sequential real options with option
  to abandon
• Economic/Market Uncertainty about prices and
  costs
• Oil prices oscillations are mean-reverting with
  jumps?
• Market volatility incentives to wait until the
  project to become deep-in-the money optimal
  exercise of the option
• Strategic Uncertainty on the other firms
  behavior
• Option-Games drilling games (Dias, 1997) OPEC
  games

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Deepwaters Technology Step-by-Step

• New discoveries of large petroleum reserves has
  been finding in deepwaters and ultra-deepwaters
• Deepwaters is the present and the future in oil
  exploration
• The conquest of deepwaters in offshore Brazil is
  a good example of the step-by-step approach
• In the 80s, diverless technology reaching 500
  meters
• In the 90s, diverless and guidelineless
  technology reached 1,853 meters (6,079 ft)
  (Roncador, 1999)
• Petrobras and others are developing technology
  for up 3,000 meters. Companhies with technology
  have the option to enter in deepwaters prospects
• The technology development for one deepwater
  oilfield gives a real option to develop other
  deepwaters oilfields
• The technology valuation must consider the real
  options that it creates, not only the immediate
  application

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Deepwaters Technology A Success History

• Most of deepwaters world records occurred in
  Campos Basin, Brazil

WATER DEPTH WORLD RECORDS1977 - 1999
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Technical Uncertainty

• Technical uncertainty decreases as the investment
  in information is performed (step-by-step
  approach).
• Geological uncertainty is reduced by the
  investment of the whole industry in a basin
• The cone of uncertainty (Amram Kulatilaka)
  can be adapted to the technical uncertainty
  understanding

HigherRisk
Lower Risk
ExpectedValue
ExpectedValue
confidence interval
Lack of Knowledge Trunk of Cone
Project evaluation with additionalinformation(
t T)
Risk reduction by the investment in information
of all firms in the basin (driver is the
investment, not directly by the passage of time)
Current project evaluation (t0)
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Technical Uncertainty

• But in addition to the risk reduction process,
  there is another important issue revelation of
  the true value
• The expected value after the investment in
  information can be very different of the initial
  estimative
• Investment in information reveals good or bad news

t T
Value withgood revelation
Value withneutral revelation
Value withbad revelation
Current project evaluation (t0)
Investment in Information
Project valueafter investment
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Technical Uncertainty

• The number of possible scenarios to be revealed
  is proportional to the cumulative investment in
  information
• Information can be costly (our investment) and/or
  free, from the other firms investment
  (free-rider)

• The arrival of information process leverage the
  option value of a tract

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EP Process and Options
Oil/Gas Success Probability p

• Drill the wildcat (pioneer)? Wait? Extend?
• Revelation additional waiting incentives

Expected Volume of Reserves B
Revised Volume B

• Appraisal phase delineation of reserves
• Technical uncertainty sequential options

• Delineated but Undeveloped Reserves.
• Develop? Wait and See for better conditions?
  Extend the option?

• Developed Reserves.
• Expand the production? Stop Temporally? Abandon?

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Valuation of Exploratory Prospect

• Suppose the case below how valuable is this
  prospect?
• Suppose that the firm has 5 years option to drill
  the wildcat
• Other firm wants to buy the rights of the tract.
  Do you sell? How valuable is the prospect?

Compact Decision-Tree
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Valuation of Exploratory Prospect

• The traditional method looks only expected
  values, forgetting that, in some scenarios (if
  NPV lt 0), rational managers will not exercise the
  option to develop the petroleum field.
• Consider the following data to quantify prospect
  value
• Petroleum prices P 15.1 /bbl
• Economic quality of a developed reserve q 20
  (so one barrel of developed reserve 0.20 x 15.1
  3.02 /bbl)
• Total value of the developed reserve V q.P.B
  3.02 x B (where B is the number of barrels of
  reserve)
• Development cost (D) dividing in fixed (271
  MM) plus variable term (1.1 /bbl of reserve),
  hence D 271 (1.1 x B)
• Using the expected value of reserve volume (B
  150 MM bbl), the value of the prospect by the
  traditional method is
• Net Present Value (NPV) given a discovery NPV
  V - D q.P.B - D ? NPV (3.02 x 150) - (271
  1.1 x 150) ? NPV 17 MM US
• But the chances to discovery petroleum is only of
  20 and is necessary to drill the wildcat with
  cost of E 20 MM. So
• Expected Monetary Value EMV - 20 (20 x 17)
  ? EMV - 16.6 MM US (and the prospect is a
  worthless asset)

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Prospect with Option to Develop

• Considering that rational managers will not
  exercise the option to develop the petroleum
  field if it is unprofitable, the prospect value
  changes a lot. See the table below.

• Considering the option, the expected monetary
  value (EMV) is EMV - 20 (20 x 100) ? EMV
  0
• Hence, now we are indifferent to drill the
  wildcat well.

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Prospect Valuation and Revelation

• The previous option analysis consider only
  uncertainty in the reserve size and the option to
  develop as a now-or-never option (option
  expiring)
• However is not a now-or-never option, it is a 5
  years option
• In 5 years we shall have many different scenarios
  due both uncertainties, market (oil prices,
  costs) and technical (geology)
• Revelation of Geology with the time, the
  exploratory activity of the whole industry in the
  basin will reveal good or bad news about the
  success probability, the productivity of reserve
  (so, the economic quality of a reserve q), the
  size of reserves, etc.
• In 5 years several wildcats shall be drilled in
  the same basin, revealing new values for success
  chances, reserve productivity and volume, etc.
• You can wait and see the revelation of
  information (free information)
• If you have an option (not an obligation), in 5
  years the option will be exercised only if the
  scenarios combination is favorable.

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Prospect Valuation under Uncertainty

• The table below present the probability
  distributions at t 5 years for some uncertain
  geologic parameters (revelation scenarios) and
  for one uncertain market parameter (oil prices).

Parameter
Distribution
Values
Success Probability for the wildcat well
Minimum 10Most Likely 20Maximum 30
Economic Quality for the Developed Reserve
Multiplicative Factor for the Reserve Size
Distribution
Minimum 0.5Most Likely 1Maximum 1.5
Mean 15.1 US/bbl
Standard-Deviation 6
US/bbl
Oil Prices
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Exploratory Prospect Uncertainty

• Considering the uncertainties in oil prices,
  economic quality of reserve, success probability
  and reserve size.
• Considering probabilistic distributions but
  keeping the same expected values (assumptions at
  t 5 y. not more optimistic)
• Without considering the options, the expected
  monetary value (EMV) _at_ t 5 years is negative as
  before (- 16.6 MMUS)

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Exploratory Prospect and Revelation

• However, _at_ t 5 years you will exercise the
  option only if the NPV is positive. So, the
  unfavorable scenarios will be pruned (if NPV lt 0,
  set value zero)
• Options asymmetry leverage prospect valuation.
  EMV 14.8

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Real Options Asymmetry and Valuation


Prospect Valuation Traditional Value - 16.6
Options Value 14.8
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Prospect Valuation under Uncertainty

• However, the value with revelation occurs in the
  future, _at_ t 5 years. Discounting this EMV using
  a discount rate 10 p.a., we get
• Present Value of EMV PV(EMV) 9.19 MM
• There is a rent tax to retain the area of
  concession, but this value is small for
  exploratory blocks
• Rental US 3,000/year PV(Rental) 0.01 MM
• Hence, the prospect value with revelation is
• Value 9.18 MM gt gt traditional value ( -16.6
  MM)
• In reality, the correct value is even higher,
  because is possible that the option becomes
  deep-in-the-money before 5 years
• Depending on both market evolution and partial
  revelation of geology, the option can be
  exercised before t 5 years

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Prospect Valuation under Uncertainty

• Considering the option feature of real assets, we
  get a very different result when comparing with
  the traditional value.
• Now is easy to see that higher uncertainty means
  higher value if you have time and flexibility
  (options)
• Higher geologic uncertainty non-mature basins
• Higher revelation potential than mature basins

• But in the valuation we consider European option
  (exercise only _at_ t 5 years). This is a lower
  bound for the true option value.
• Considering an American option (option can be
  exercise earlier), this value is even higher
• Correct PV(EMV) gt 9.18 MM

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EP Process and Options
Oil/Gas Success Probability p

• Drill the wildcat (pioneer)? Wait? Extend?
• Revelation additional waiting incentives

Expected Volume of Reserves B
Revised Volume B

• Appraisal phase delineation of reserves
• Technical uncertainty sequential options

• Delineated but Undeveloped Reserves.
• Develop? Wait and See for better conditions?
  Extend the option?

• Developed Reserves.
• Expand the production? Stop Temporally? Abandon?

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Sequential Options (Dias, 1997)
Compact Decision-Tree
Note in million US
( Developed Reserves Value )
( Appraisal Investment 3 wells )
( Development Investment )
EMV - 15 20 x (400 - 50 - 300) ? EMV - 5
MM
( Wildcat Investment )

• Traditional method, looking only expected values,
  undervaluate the prospect (EMV - 5 MM US)
• There are sequential options, not sequential
  obligations
• There are uncertainties, not a single scenario.

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Sequential Options and Uncertainty

• Suppose that each appraisal well reveal 2
  scenarios (good and bad news)

• development option will not be exercised by
  rational managers

• option to continue the appraisal phase
  will not be exercised by rational managers

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Option to Abandon the Project

• Assume it is a now or never option
• If we get continuous bad news, is better to stop
  investment
• Sequential options turns the EMV to a positive
  value
• The EMV gain is
• 3.25 - (- 5) 8.25 being

2.25 stopping development 6 stopping
appraisal 8.25 total EMV gain
(Values in millions)
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EP Process and Options
Oil/Gas Success Probability p

• Drill the pioneer? Wait? Extend?
• Revelation, option-game waiting incentives

Expected Volume of Reserves B
Revised Volume B

• Appraisal phase delineation of reserves
• Technical uncertainty sequential options

• Delineated but Undeveloped Reserves
• Develop? Wait and See for better conditions?
  Extend the option?

• Developed Reserves.
• Expand the production? Stop Temporally? Abandon?

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The Extendible Maturity Feature
Period
Available Options
Develop Now or Wait and See
Develop Now or Extend (pay K) or Give-up
(Return to Government)
T I M E
Develop Now or Wait and See
Develop Now or Give-up (Return to Government)
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Extendible Options Dias Rocha (1998/9)

• Options with extendible maturities was studied
  by Longstaff (1990) for financial applications
• We (Dias Rocha, 1998/9) apply the extendible
  options framework for petroleum concessions.
• The extendible feature occurs in Brazil, Europe,
  USA
• Base case of 5 years plus 3 years by paying a fee
  K (taxes and/or additional exploratory work).
• Included into model benefit recovered from the
  fee K
• Part of the extension fee can be used as benefit
  (reducing the development investment for the
  second period, D2)
• We consider both stochastic processes for oil
  prices, the traditional geometric Brownian motion
  and the more realistic mean-reversion process
  with jumps

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Extendible Option Payoff at the First Expiration

• At the first expiration (T1), the firm can
  develop the field, or extend the option, or
  give-up/back to govern
• For geometric Brownian motion, the payoff at T1
  is

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Nominal Prices for Brent and Similar Oils
(1970-1999)

• We see oil prices jumps in both directions,
  depending of the kind of abnormal news jumps-up
  in 1973/4, 1978/9, 1990, 1999 and jumps-down in
  1986, 1991, 1997

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Poisson-Gaussian Stochastic Process

• We adapt the Merton (1976) jump-diffusion idea
  for the oil prices case, considering
• Normal news cause only marginal adjustment in oil
  prices, modeled with a continuous-time process
• Abnormal rare news (war, OPEC surprises,...)
  cause abnormal adjustment (jumps) in petroleum
  prices, modeled with a discrete time Poisson
  process
• Differences between our model and Merton model
• Continuous time process mean-reversion instead
  the geometric Brownian motion (more logic for oil
  prices)
• Uncertainty on the jumps size two truncated
  normal distributions instead the lognormal
  distribution
• Extendible American option instead European
  vanilla
• Jumps can be systematic instead non-systematic

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C Software Interface The Main Window

• Software solves extendible options for 3
  different stochastic processes and two methods
  (dynamic programming and contingent claims)

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The Options and Payoffs for Both Periods
Options Charts
Period
T I M E
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Real Applications of this Model

• A similar stochastic process of mean-reversion
  with jumps was used to equity design (US 200
  millions) for the Project Finance of Marlim field
  (deepwaters, Brazil)
• The extendible options has been used to analyze
  the development timing of some projects in Campos
  Basin
• The timing policy was object of a public debate
  in Brazil, with oil companies wanting a higher
  timing and this model gave some contribution to
  this debate
• We defended a longer timing policy compared with
  the first version of the ANP (Brazilian national
  petroleum agency)
• In April/99, the notable economist and
  ex-Minister Delfim Netto defended a timing policy
  for petroleum sector citing our paper conclusions
  about timing policies to support his view! (Folha
  de São Paulo, a top Brazilian newspaper)

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EP Process and Options
Oil/Gas Success Probability p

• Drill the pioneer? Wait? Extend?
• Revelation, option-game waiting incentives

Expected Volume of Reserves B
Revised Volume B

• Appraisal phase delineation of reserves
• Technical uncertainty sequential options

• Delineated but Undeveloped Reserves.
• Develop? Wait and See for better conditions?
  Extend the option?

• Developed Reserves.
• Expand the production? Stop Temporally? Abandon?

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Option to Expand the Production

• Analyzing a large ultra-deepwater project in
  Campos Basin, we faced two problems
• Remaining technical uncertainty of reservoirs is
  still important. In this specific case, the
  better way to solve the uncertainty is by looking
  the production profile instead drilling
  additional appraisal wells
• In the preliminary development plan, some wells
  presented both reservoir risk and small NPV.
• Some wells with small positive NPV (not
  deep-in-the-money) and others even with
  negative NPV
• Depending of the initial production information,
  some wells can be not necessary
• Solution leave these wells as optional wells
• Small investment to permit a future integration
  of these wells, depending of the market evolution
  and the production profile response

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Modelling the Option to Expand

• Define the quantity of wells deep-in-the-money
  to start the basic investment in development
• Define the maximum number of optional wells
• Define the timing (or the accumulated production)
  that the reservoir information will be revealed
• Define the scenarios (or distributions) of
  marginal production of each optional well as
  function of time.
• Consider the depletion if we wait after learn
  about reservoir
• Simplify considering yearly distributions and
  limiting the expiration of the option (declining
  NPV due the depletion)
• Add market uncertainty (reversion jumps for oil
  prices)
• Combine uncertainties using Monte Carlo
  simulation
• Use optimization method to consider the earlier
  exercise of the option to drill the wells, and
  calculate option value
• Monte Carlo for American options is a frontier
  research area

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Conclusions

• Real Options is the new paradigm for economic
  analysis of assets, projects, and opportunities
  under uncertainty.
• Real options can be viewed as a NPV maximization
  given the options and given the
  uncertainties/stochastic processes
• Need training, knowledge, and good computers
• Valuation of rights/projects using traditional
  methods underestimates values, resulting on very
  wrong values.
• Implications for petroleum real assets
  negotiations, bids, etc.
• Implications for investment decisions and
  portfolio selection
• Firms need to develop simple and more complex
  models.
• Simple models are important for fast
  calculations.
• Interactive interface, charts, and educational
  work.
• Real world and specific issues demand also more
  complex and taylor-made models in-house models
• Firms need to follow the state of the art and the
  growing literature