Real Options Analysis on the Value and Managerial Flexibility of an Oil Project

Fu Xiangshan

Abstract

Valuing an undeveloped oil field and pricing the option to invest in such an oil field is the theme of the present thesis. The NPV approach was found to be inadequate for valuing project of this kind. This is because, first the approach ignores management’s freedom to postpone investment; second it ignores the stochastic nature of price movements and management’s ability to hedge bad outcomes through flexible production plans. Hence, some scholars have used real options techniques to value oil projects. However, all of these scholars have used Geometric Brownian Motion (GBM) to describe the stochastic process of oil prices which were evidenced by literature in the past ten years to follow a mean-reversion process. Besides, none of the scholars have considered “construction lag” in their valuation approach. But in reality, it takes time to build the production facilities.

The present thesis develops, progressively, a real options framework for valuing an undeveloped oil field. The base model assumes the value of an oil project follows a mean-reversion process, and calculates the option value accordingly. The second model assumes the oil price follows a mean-reversion process; takes into account operating cost; and allows temporary costless suspension and variable output. The last model incorporates “construction lag” into the valuation framework and shows how Finite Difference Method can be invoked to solve the partial differential equation. To demonstrate the use of the proposed framework, a numerical example is given in Chapter 4. An R program is developed to calculate critical oil prices, project values, and option values. Sensitivity analysis on key parameters is also discussed.

This thesis has thus overcome the drawbacks of previous works by modeling oil prices as a mean reverting process instead of GBM; and by incorporating “construction lag” into the valuation framework. Besides, the R program enables investors to use the proposed framework with ease. Moreover, the framework developed in the thesis is quite general, and does not consider factors such as corporate income tax, governance license, etc. Therefore, it is quite flexible for extension. Furthermore, the framework is not only applicable to oil projects, but can be used to value any project that is derivative of a basic tradable asset whose price follows a mean-reversion process.