REAL OPTION

An Alternative Approach of Oil & Gas

Investment Valuation

BENNY LUBIANTARA

Presented in IATMI Conference ,2000

 Background
 Objectives
 Investment Valuation Using DCF
Method
 DCF Method in Practice
 Introduction to Option Pricing Theory
 What is Real Option
 Real Option for Investment Valuation
 Application : Simple Case Study
 Summary
 What Next ?
PRESENTATION BACKGROUND
VALUATION
MODELS

DCF
Models Relative Option
Valuation Pricing
Models Models

“Real
Options”
Model
 Objectives :
 To demonstrate how financial option
pricing theory can be applied to
evaluate investment in oil and gas
business.

 To demonstrate the Difference from

traditional Discounted Cash Flow
(DCF) Method.
 Investment Valuation
using DCF Method :
INVESTMENT CRITERIA :

 NPV
 IRR
 Payback Period
 Profitability Index
 DCF METHOD
(In Practice)
Modify DCF Traditional Method Using :
 Sensitivity Analysis
 Scenario Analysis
 Simulation Analysis
 Decision Tree
 Influence Diagram
 Multiple Discount Rate
 Weighted Average Discount Rate
(WADR)
 Oil prices are very unpredictable, it is not
easy task to estimate future cash flow.
 Does not take into account the flexibility
available in a typical project
 Difficult to estimate an appropriate discount
rate which reflects the risks of the cash flow.
Traditional DCF miss flexibility ?

DCF :

Invest Accept
Outcome

In Reality :

Invest Learn Modify Outcome

 Introduction to
Option Pricing Theory

What is an Option ?
An option is a contract which gives
its holder the right, but not the
obligation, to buy (or sell) an asset
at some predetermined price within
a specified period of time.
 Introduction to
Option Pricing Theory

Type of Options :
 A call option gives the buyer the right to buy the
underlying asset at a fixed price - the strike or
exercise price (X) at some time before the
expiration date of the option.

 A put option gives the buyer the right to sell

the underlying asset at the strike price.
 Introduction to
Option Pricing Theory

 European option : It gives a holder the

right to buy (or sell) a particular stock at a
specified price at maturity date.

 American option : An option that can be

exercised at any time on or before the
maturity date.
Determinants of Option Values
 Variables relating to stock
 stock price
 dividends paid

 stock price variance

 Variables relating to option characteristics

 strike price
 European or American option

 time to expiration

 Variable relating to financial markets

 r, risk-free interest rate
 OPTION VALUATION

Based on idea of replicating portfolio, i.e., a

portfolio composed of the underlying asset and
a riskless asset which generates the same
cash flow as the option

Two General Approaches

Binomial
Black-Scholes
 OPTION VALUATION
BINOMIAL MODEL
Consider an asset movement following a
binomial process, and a call option on the asset.
uS
Cu=max(uS-K,0)
p
S
C

1-p dS
Cd=max(dS-K,0)
 OPTION VALUATION

The call option price can be written as :

rt
C e ( pCu (1 p)Cd )

Which is :
e rt d
p
u d
 OPTION VALUATION
General Formula for Binomial Model :

rt
ci , j e ( pci 1, j 1 (1 p)ci 1, j )
 OPTION VALUATION
BLACK-SCHOLES FORMULA
Assumption : Stock follow the stochastic process,
called Geometric Brownian Motion (GBM) :
dS
dt dz
S
, are constants
dt: percent average return on the asset during a small
interval
: volatility of the asset
dz Wiener process

dz ~ dt
= random drawing from a standardized normal distribution
 OPTION VALUATION
B-S Differential Equation :
2
c c 1 2 2 c
rs s rc 0
t s 2 s2

Additional Assumptions :

 No dividends during the option’s life.

 No transactions costs.

 rf is known and constant during the option’s life.

 Option can be exercised only on its expiration date.

 OPTION VALUATION
B-S Formula :

rt
C S N(d ) Xe N(d )
1 2
Notation :
Where :
S, Current Stock price
2 X, Exercise Price
LN(S/X) (r /2)t t, Time to Expiration
d
1 t , Volatility of the return of the stock
r, Risk Free Interest Rate
d d t N(d), Cum.Probability Distribution Function
2 1
 WHAT IS REAL OPTION ?

Real Option is the analogy from the

financial option for real asset (non
financial asset).

An Option on a non traded asset, such as

an investment project, oil and gas
reserve, gold mine, etc.
 COMMON REAL OPTIONS

Option to Defer (“wait and learn”)

The firm can wait several years to see if market condition
justify constructing the plant or developing the field.

Option to Expand
If market and technical condition are more favorable than
expected, the firm can expand the scale of production.

Option to Abandon
If market condition decline severely, the firm can abandon
the operation and realize the resale value of capital
equipment or other assets on the second hand market.
Options in Oil and Gas E&P :
•Develop ?
•“Wait and See” for Better Condition ?

Developed Reserve
• Expand ? Stop Temporarily ? Abandon ?
 Analogy
Financial Option - Oil Reserves
CALL OPTION UNDEVELOPED RESERVES

S Current Stock Price Current Value of Developed Reserve

Volatility of Rate of Volatility of Rate of Change of the

Return on the Stock Value of a Developed Reserve

X Exercise Price Development Cost

T Time to Expiration Relinquishment Requirement

r Risk Free Rate of Risk Free Rate of Interest

Interest
 REAL OPTION
for Investment Valuation
Options Identification Stage

Mathematical Modeling

Solutions

Partial Differential Dynamic Simulation

Equation Programming Analysis

- Analytical Solution - Binomial Model

(B-S Formula) - Trinomial Model - Monte Carlo
- Numerical Solution
 Application :
Simple Case Study : 1
 Offshore deepwater oilfield “XYZ” has estimated oil
reserves : 1 MMBO
 Development cost = US$ 18/barrel
 Current oil price = US$ 15/barrel
 t= 10 years
 Volatility = 5%
 Risk Free interest rate = 8%

Using B-S formula, we will obtain the value : US$ 691,210

 According to BS-calculation, this oil reserves, even
though not viable at current price, still is a valuable
property because of its potential to create value if oil
prices go up.
 This is not captured by traditional DCF method.
 Simple Case Study : 2
PRODUCTION FORECAST "BL-1" FIELD

60,000

50,000

40,000

30,000

20,000

10,000

-
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19

DATA :
Development cost $ 2,500,000
Yearly operation costs $ 100,000
Current oil price $16/bbl
Volatility 25%
Risk free interest rate / Rf 5%
Relinquishment period 20 years
Depreciation 5 years
 Simple Case Study : 2
If we consider only option to defer, the calculation for both DCF and real option
as follows :

Value of Field "BL-1"

6
5 DCF
4 OPM
3
2
Millions

1
-
(1) 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35
(2)
(3)
(4)
Price

It is better to wait until the oil price reach $18.5 per barrel to start developing
the project, below that price, the option value is worth more than “now or
never” decision (as calculated using DCF method).
 SUMMARY

 Real Options is the new paradigm for

economics analysis of asset, projects
and opportunities.

 This technique is most useful when the

analyzed projects have significant
options and the future is uncertain.