Transcript of "REAL OPTIONS ANALYSIS OF MARGINAL OILFIELD DEVELOPMENT PROJECTS: THE CASE OF THE UKCS "
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REAL OPTIONS ANALYSIS OF MARGINAL OILFIELDDEVELOPMENT PROJECTS: THE CASE OF THE UKCS By: Theophilus Acheampong MSc (Econ) in International Business, Energy & Petroleum December, 2010
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OVERVIEW 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 Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum University of Aberdeen, Aberdeen, U.K.
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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.
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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.
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Understanding The Concept 2 : The “Total Value” Approach Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum University of Aberdeen, Aberdeen, U.K.
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Understanding The Concept 3: Decision Tree Analysis & Real Options Preserve Field High Probability, λ Develop Field Low Probability, (1-λ)Oilfield Investment Preserve Field High Probability, λ Develop Field Preserve Field Low Probability, (1-λ) Develop Field Work Backwards Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum University of Aberdeen, Aberdeen, U.K.
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Understanding The Concept 4 : (E&P as a Sequential Real Options Process) Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum University of Aberdeen, Aberdeen, U.K.
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Case Study 1 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). Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum University of Aberdeen, Aberdeen, U.K.
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Case Study 2: Methodology Deferral Option Fig 1: Valuation Methodology Summary Model Option Valuation Expansion Option Key Input Data Base NPV Model Parameters Model Abandonment Option Model Option Valuation Key Input Data DCF Base Model Embedded Project Options Parameters• Revenues - Oil prices and • Cash Flows – Pre and Post • Identify and model project • Deferral Option Base Value Production volumes Tax Basis uncertainties and Sensitivity Analysis • Estimate project• Costs - Tariffs, • Base NPV, IRR, Payback volatilities using MC • Expansion Option Base Development and Period Profitability Index Simulation Value and Sensitivity Operating expenditures Analysis • Calculate the other 5 • DCF Sensitivity Analysis – determinants of the • Abandonment Option• Other data - such as the e.g. Monte Carlo option value (e.g. strike Base Value and Sensitivity UK Fiscal Terms and Simulation price) Analysis Discount Rate (Cost of Capital) • Estimate option values using opting pricing methods (e.g. Binomial Lattice)
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Case Study 3: Main Results PROJECT PROFITABILITY METRICSBase Case NPV NPV $M 262.30 Note: Expanded IRR 65.7% NPV = Base NPV Profitability Index 1.23 + Option ValueReal Options Analysis Values Deferral Option $M 317.21(Expanded NPV) Expansion Option $M 270.13 Abandonment Option $M 262.31 400 350 317.21 300 262.30 270.13 Values ($ million) 262.30 262.31 250 262.30 Project Values with 200 Flexibility (Base Case Scenario) 150 100 50 - Deferral Option Expansion Option Real Options Analyis Value Abandonment Option Static NPV Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum University of Aberdeen, Aberdeen, U.K.
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Summary & Conclusions 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 Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum University of Aberdeen, Aberdeen, U.K.
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APPENDIX Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum University of Aberdeen, Aberdeen, U.K.
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Classical Model of Real Options in Petroleum 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 Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum University of Aberdeen, Aberdeen, U.K.
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Option Calculation Simulation Continuous Discrete Monte Carlo Simulation Black/Scholes & Derivatives Binomial Trees+ Easy to understand + Mathematically elegant + Easy to understand + Applicable to all Real Options+ Applicable to all Real + Relatively easy to calculate manually constructs Options constructs + Simple Real Options modelling + Fast calculation− Very laborious − Complex to very complex − Very laborious implementation implementation with Excel − Hard to understand for practitioners− Slow calculation − Limited applicability − Interpretation of results not− Delicate issues in valuation very intuitive of Real Options (correlations, probabilities) etc) Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum University of Aberdeen, Aberdeen, U.K.
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Some Important Scientific Foundations of Real Options Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum University of Aberdeen, Aberdeen, U.K.
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