Master Thesis - Real Option Valuation of oil and gas megaprojects

Antoine Paillat
Financial Valuation of oil and
gas megaprojects using real
option theory
December 3, 2014

1. Problem Statement
2. Literature review of Real Option Theory
3. Methodology
4. Findings and Discussion
5. Conclusion
2

© 2012, IHS Inc. No portion of this presentation may be reproduced, reused, or otherwise distributed in any form without prior written consent.
Problem Statement
3
The E&P megaprojects budget overruns follow a long-term trend of growth in project size, driving E&P
capital spending fourfold during the last decade, and draining more and more operators in such large
projects.
4
Average
budget
overruns
a long-
g E&P
decade,
n such
ess the
t-crisis
to see
rojects
ectives: Challenges of E&P Megaproject Delivery, Summer Issue.
1. Main Research Question
Could we indentify and measure the added value of flexibility in oil and gas megaprojects, by performing
simple real options financial valuations?
2. Secondary Research Question
Using the valuation results, which investment recommendations and strategic guidance could be provided
to oil and gas decision-makers regarding investments in megaprojects?

2. Literature Review
3. Methodology
5. Conclusion
4

Literature Review
5
1.  Dealing with the uncertainty
(1994) Dixit and R. Pindyck, Investing under uncertainty, Princeton University Press
If the investment is subject to uncertainty and irreversibility, there is a posistive real option
value which is not highlighted by the standard “NPV > 0 rule”
amount of mathematics, when investment decisions are made at discrete points of time. Following
is their simple yet famous example of the widget factory. In this case, a firm has the opportunity to
invest = 1600 to build a factory able to produce one widget per year, with zero operating costs.
Currently the price of a widget is $200, but for next year the price there is a q probability that it
will rise to $300, and a (1-q) probability that it will fall to $100. Then price the price is assumed to
remain at this new level forever. The discount rate is set at 10%.
a) Payoff structure of the widget factory
t=0 t=1 t=2 t=3 …
P0 = 200
q=0.5 P1 = 300 P2 = 300 P3 = 300
1-q P1 = 100 P2 = 100 P3 = 100
b) Standard NPV calculation
Investing right now, the only widget price expected is $200
c) NPV calculation with flexibility
simple yet famous example of the widget factory. In this case, a firm has the opportunity to
= 1600 to build a factory able to produce one widget per year, with zero operating costs.
tly the price of a widget is $200, but for next year the price there is a q probability that it
e to $300, and a (1-q) probability that it will fall to $100. Then price the price is assumed to
at this new level forever. The discount rate is set at 10%.
Payoff structure of the widget factory
t=0 t=1 t=2 t=3 …
= 200
q=0.5 P1 = 300 P2 = 300 P3 = 300
1-q P1 = 100 P2 = 100 P3 = 100
Standard NPV calculation
NPV calculation with flexibility
Wainting one year, and investing only if the widget price rises to 300 (q=0.5)
11
t=0 t=1 t=2 t=3
P0 = 200
q=0.5 P1 = 300 P2 = 300 P3 = 300
1-q P1 = 100 P2 = 100 P3 = 100
b) Standard NPV calculation
c) NPV calculation with flexibility
Wainting one year, and investing only if the widget price rises to 300 (q=0.5)

Literature Review
6
2. Common real options in the oil and gas sector
(2002) C.R. Harvey, Identifying real options, Duke University Press
(2003) Oilfield Review, Unlocking the Value of Real Options
industry. As this study does not cover the field of project engineering, we will not look at “in”
projects real options. In the oil and gas sector, common examples of “in” projects real options are
product flexibility options21
, process flexibility options22
, and intensity options23
.
“On” projects real options in the following pages have been studied in greater details by C.R.
Harvey in his paper Identifying real options (2002), Duke University Press.
II.2.2 Delay option
Generic description:
Exactly the one revealed above in the ‘widget factory’ case. It is the option to delay the
investment until the economic conditions become more favorable.
Oil and gas:
Equivalent to delaying the investment in an oilfield until the market price for crude oil makes
it economically viable.
Financial markets analogy:
Buying a call option which is not yet
“in the money”.
S: Stock Price (PV of Cash-Flows)
X: Premium (First CAPEX)
T: Maturity (Time on lease)
21
Ex: Being able to dynamically vary the share of middle distillates in the refining output
S
X
T
Delay until the
projects start
+
-
2.1. Delay Option

Literature Review
7
2.2. Abandon or Termination optionII.2.3 Abandon option
It is the option to definitely abandon a project during its life, i.e. the right to sell the remaining
cash flows for some salvage value.
Oil and gas:
From the point of view of an oil and gas operator (a major), it is equivalent to abandoning the
development of an oilfield and selling the expected cash-flows of the project to the resources
owner (a NOC) at a contractually settled price.
Buying a put option which will be
exercised to abandon the project.
II.2.4 Contract option
T
X
S
The project is
terminated
+
-

Literature Review
8
2.3. Contract option
15
II.2.4 Contract option
It is the option to contract – partially or entirely – the output of the project.
Oil and gas:
From the point of view of an oil and gas operator (a major), it is equivalent to contracting the
development of an oilfield to another society (an oilfield services company), thus selling the
expected cash-flows by paying contractually settled fees.
Buying a put option which will be
exercised to contract the project.
X: Premium (OFS fees)
-
+
The project is
contracted
S
T
X
X
S
-

Literature Review
9
2.4. Expand optionII.2.5 Expand option
It is the option to expand the project the capacity in excess of what was initially planned.
Oil and gas:
From the point of view of an operator (a major), it is equivalent to expanding production to a
satellite oilfield nearby, thus increasing the production output.
Buying a call option which will be
exercised to lauch the expansion.
X: Premium (Expansion CAPEX)
II.2.6 Grow, defer, quit, and limitless possibilities
+
The project is
expanded
S
X
T
-

Literature Review
10
3. Real option valuation methods
3.1. The Black-Scholes Model
(1973) F. Black, M. Scholes and R. Merton, The Pricing of Options and Corporate Liabilities
II.3 Overview of valuation methods
II.3.1 Black-Scholes model (BSM)
F. Black, M. Scholes and R. Merton (1973) showed that options can be priced using the risk-free
arbitrage principle, without the need to estimate distributions of returns26
. The Black-Scholes
formula estimates the value of a call option C :
Where:
The price of a corresponding put option is:
Terms Financial option Oil and gas real option
Cumulative normal distribution function
Time to maturity Time on lease
Spot price of the underlying asset NPV of developed reserves
Strike price PV of expenditures
Volatility of stock price Volatility of cash-flows from the project
Dividends foregone Revenues or profits foregone
. The Black-Scholes
Where:
. The Black-Scholes
Where:
. The Black-Scholes
Where:
18
. The Black-Scholes
Where:
26
F. Black, M. Scholes and R. Merton (1973) The Pricing of Options and Corporate Liabilities, The Journal of Political Economy,
vol. 81, issue 3, University of Chicago Press.
At the money (S=X)
Working only for European27
options, the closed-form Black-Scholes formula has limited
applicability. However, the Black-Scholes partial differential equation can be used to price
American and compound options, thus having far wider applicability28
. For ‘at the money
option’29
, an approximate formula has been found by Brenner and Subrahmanyam for “at the
money” options30
:
To enhance the practical applicability of the model, T.A. Luehrman proposed a simple framework
31

Literature Review
11
3.2. Binomial option pricing model
(1979) J.C. Cox, S.A. Ross and M. Rubinstein, Option pricing: A simplified approach
II.3.2 Binomial options pricing model
proposed by Cox, Ross and Rubinstein in 197932
, the binomial options pricing model (BOPM)
a ‘discrete-time’ (lattice) model to value both European and American option.
ch time step, a binomial lattice could only
up or down. Two factors u and d,
ions of the volatility σ , are applied to
mine the upward and downward moves.
;
e case of Cox, Ross and Rubeinstein’s
nstration, the discount rate used is the risk-
ate (r). With the variables detailed above
btain the probability (p) such as:
First proposed by Cox, Ross and
Rubinstein in 197932, the binomial
options pricing model (BOPM) uses a
‘discrete-time’ (lattice) model to value
both European and American option.
II.3.2 Binomial options pricing model
First proposed by Cox, Ross and Rubinstein in 197932
, the binomial options pricing model (BOPM)
uses a ‘discrete-time’ (lattice) model to value both European and American option.
In each time step, a binomial lattice could only
move up or down. Two factors u and d,
functions of the volatility σ , are applied to
determine the upward and downward moves.
;
In the case of Cox, Ross and Rubeinstein’s
demonstration, the discount rate used is the risk-
free rate (r). With the variables detailed above
we obtain the probability (p) such as:
In each time step, a binomial lattice could only
move up or down. Two factors u and d,
functions of the volatility σ , are applied to
determine the upward and downward moves.
;
In the case of Cox, Ross and Rubeinstein’s
demonstration, the discount rate used is the risk-
free rate (r). With the variables detailed above
we obtain the probability (p) such as:
Estimating volatility is the key part of constructing the lattice. Some ROA practitioners argue
whether technical and market uncertainties should be aggregated or separated33
. Then, valuation is
performed by starting at the end nodes of the tree and then working backwards until the first
node. At each stage the binomial tree gives the option value at that point in time such as:
e the upward and downward moves.
;
case of Cox, Ross and Rubeinstein’s
ration, the discount rate used is the risk-
(r). With the variables detailed above
n the probability (p) such as:
ng volatility is the key part of constructing the lattice. Some ROA practitioners argue
technical and market uncertainties should be aggregated or separated33
. Then, valuation is
ed by starting at the end nodes of the tree and then working backwards until the first
each stage the binomial tree gives the option value at that point in time such as:
Estimating the volatility is the key part of constructing the tree.

Literature Review
12
3.3. Finite differences method
(1977) E.S. Schwartz, The Valuation of Warrants: Implementing a New Approach
(2000) G. Cortazar, Simulation and Numerical Methods in Real Options Valuation
The two basic finite differences are the implicit and the explicit method. The former is the more
robust one, and both have been proposed by E.S. Schwartz (1977)
Using finite differences is an alternative to binomial trees to solve the valuation equation.
This resolution method being beyond the numerical capabilities of the author, the following lines
have been adapted from G. Cortazar (2000) Simulation and Numerical Methods in Real Options
Valuation, Pontificia Universidad Catolica de Chile34
.
Under standard no-arbitrage conditions, the Black-Scholes differential equation can be derived for
the value of the option C(S,t):
Boundary equation at maturity:
S being an absorption state:
robust one, and both have been proposed by E.S. Schwartz (1977)35
. The second is relatively
clearly exposed by G. Cortazar in its working paper mentioned above.
We encourage the readers interested in the matter to go through these papers. The main insight of
the finite differences method is to provide a more precise valuation for options on dividend paying
.
stocks36
.
.
stocks36
.
The main idea is to simulate price trajectories following a geometric Brownian motion. Volatility is found
through random sampling form the normal distribution. The method aims at approximating probability
distributions of terminal asset values, using the risk-free interest rate as a point estimator of the option
value. This method is harder to used with American option.
3.4. The Monte-Carlo specialized methods
(1977) P. Boyle, Options: A Monte-Carlo Approach, Journal of Financial Economics

3. Methodology
5. Conclusion
13

Methodology
14
1.  Selection of Projects
III. METHODOLOGY
III.1 Selection of Projects
The year of reference is 2013. All data is updated as of January 1st
, 2013. A ‘project’ is composed
of the main oilfield development and of the possible expansions to its satellite oilfields43
.
11 megaprojects have been selected according to the following criteria:
Total CAPEX of the project above $1 billon
Operating costs and Government take data availability
Capital costs data availability
Projects types: Conventional Land, Deepwater Oil, LNG, Oil Sands and EOR projects44
Recent or upcoming activity on the project45
Project Type Land Deepwater LNG Oil Sands EOR
Countries Iraq
Azerbaijan,
Nigeria, Brazil
Russia Canada Norway
Projects 2 3 2 2 2
Possible
expansions
1 3 1 1 2

Methodology
15
2. Data Collection
Sources:
IHS (CERA, Herold and EDIN), Rystad Energy, US EIA, WoodMackenzie, Reuters,
WorldBank, NYU Stern, misc.
3.  Valuation Method
3.1. Why the binomial tree?
§  All the data was available at the annual frequency, making then more sense for a
discrete time model.
§  Forecast data available enabled most of the uncertainty to be restrained to price
volatility, making it suitable for a NPV-modified calculation.
§  Ease of use and little amount of mathematics.

Methodology
16
3.  Valuation Method
3.2. Parameters
III.3.2 Parameters
As we use a standard DCF method to compute the modified NPV with flexibility, the parameters
are the ones commonly used to value a project: Price, Production, CAPEX, OPEX, discount rate
and time.
a) Crude oil prices
Parameters:
Calibration targets
It is not really surprising to see that u > d. Crude oil being a finite resource, its scarcity leads to a
permanent upward pressure on prices in the long term. u and d have been set at respectively 0.20
and 0.15 in order to calibrate the average prices on the long-term crude oil prices forecasts
available, i.e. IHS until 2040, and Rystad afterwards, as below:
IHS Rystad Lattice IHS Rystad Lattice
Brent Brent Average Brent Brent Average
Year $/bbl $/bbl $/bbl Year $/bbl $/bbl $/bbl
2014 106.15 106.33 111.27 2033 168.00 162.92 177.89
discussed later on.
At each node:
n t=1
q=0.5
1-q
Using Excel’s random function, at each node the price follows the upward or downward path.
For instance, at the first nodes of the tree:
b) Carbon prices

Methodology
17
30
b) Carbon prices
Carbon prices are simulated in order to calculate the carbon emissions costs at the wellhead. As we
will see, it does not make that much a difference at the end. However, as we had to forecast cash-
flows as far as 2050, it makes some sense to consider rising environment-related costs constraints.
Such constraints could reasonably be assumed to contain some uncertainty materialized by volatile
carbon market met prices. As a result, those prices have been modeled using the same method as
described above.
Parameters:
Calibration targets
Once again, u > d. Environmental costs follow an upward trend, and it does not seem irrelevant t
assume that those costs will be higher in 2050 than there are today. u and d have been set a
respectively 0.30 and 0.10 in order to calibrate the average prices on the long-term carbon price
forecasts available, i.e. IHS until 2040, as below:
IHS Lattice IHS Lattice
EU ETS Average EU ETS Average
Year $/metric ton $/metric ton Year $/bbl $/bbl
2014 9.08 6.60 2033 51.46 40.38
2015 13.68 7.26 2034 54.63 44.42
2016 17.09 7.99 2035 57.96 48.86
2017 19.46 8.79 2036 61.43 53.75
2018 20.78 9.67 2037 64.99 59.12
2019 22.27 10.63 2038 68.66 65.03
At the first node 2013-2014, we obtain:
n t=1
q=0.5
1-q
As above, here is an example of the price path at the early nodes of the tree:
c) Production
Production data in kboe/d. Natural gas output has been converted into barrels equivalent using
standard conversion factors50
.
d) CAPEX
Capital expenditures in million US dollars. Distinction has been made between initial CAPEX and
intermediary project CAPEX.
1-q
As above, here is an example of the price path at the early nodes of the tree:
c) Production
Production data in kboe/d. Natural gas output has been converted into barrels equivalent using
standard conversion factors50
.
d) CAPEX
Capital expenditures in million US dollars. Distinction has been made between initial CAPEX and
intermediary project CAPEX.

Methodology
e) OPEX
Projects’ operating costs: Forecast data (MUSD)
Government take: Forecast data (MUSD)
Carbon emissions compensation costs:
51
f) Discount rate
The oil and gas cost of -capital is calculated as:
In 2013, for oil and gas producing activities, we have52
:
e) OPEX
51
f) Discount rate
:
e) OPEX
51
f) Discount rate
:

Methodology
3.3. Assumptions: A quick summary
34
appears to be marginal after that, especially in comparison of the incremental output brought on-
stream by the expansion projects. Please see the projects summary tables in section ‘Selection of
projects’.
III.3.3 Assumptions: A quick summary
Crude oil price is the main source of uncertainty, price volatility can be estimated using
a binomial-lattice tree building according to the parameters detailed above.
A project is studied at the scale of a complex of oilfields. Expansions projects concern
undeveloped satellite oilfields.
Current shareowners rights, specific contracts’ clauses and other transaction costs are
neglected.
53
Aswath Damadoran, Country Risk Premiums, 2013. Dataset available online: http://pages.stern.nyu.edu/~adamodar/
54
World Bank data, Iraq risk premium on lending 2012-2013, available online: http://data.worldbank.org/indicator
Taxation costs are reflected by the ‘government take’ forecast data.
The project discount rate is equal to the upstream industry average cost of capital plus a
country risk premium.
Natural gas production can be monetized for its equivalent volume in liquids at the market
crude oil price.
Carbon wellhead emissions can be estimated using crude oil benchmarks data.
Time remaining on lease is equal to the time until production output from the field become
marginal.

3. Methodology
5. Conclusion
20

Findings and Discussion
1. Projects Valuation
A striking example : Bonga Deepwater & Bonga Southwest-Aparo extensionb) Financial metrics
As of 2013 ACG
Chirag
Expansion
Bonga
Bonga
Southwest-
Aparo
Lula Lula South
Time length 18 years 7 years 12 years 21 years 18 years 21 years
Peak rate
kboe/d
1,035
kboe/d
183
kboe/d
250 kboe/d 225 kboe/d
1,000
kboe/d
120 kboe/d
Wellhead
emissions
28 kCO2/bbl 28 kCO2/bbl 77 kCO2/bbl 77 kCO2/bbl 32 kCO2/bbl 32 kCO2/bbl
First
CAPEX
$0 $6.0 billion $0 $9.0 billion
$10.0
billion
$3.75
billion
Total
CAPEX
$0 $6.0 billion $0
$12.0
billion
$80.0
billion
$3.75
billion
Discount
rate
12.06% 12.06% 14.08% 14.08% 11.68% 11.68%

Total CAPEX (MUSD, post-2013) 0 0 6 000
PIR (Profit Investment Ratio) - - 7,75
DEEPWATER OIL PROJECTS BONGA
Project Flexibility (with/without) No flexibility Abandon Expand
Delay +
Expand +
Abandon
Average NPV (MUSD) -2 400 500 7 300 23 700
Option Value (MUSD) 0 2 900 6 800 26 100
VaR at 10% 6 000 0 8 200 0
VaR at 20% 5 000 0 4 000 0
VaR at 33% 4 000 0 0 0
VaR = 0 Probability 80% 80% 33% -
Initial CAPEX (MUSD) 0 0 9 000 12 000
Total CAPEX (MUSD, post-2013) 0 0 12 000 12 000
PIR (Profit Investment Ratio) - - 1.61 2.98

Bonga NPV distribution – No flexibility VS Expand
he Bonga project, it seems really interesting to take a close look at the expand option (above).
out flexibility, the average NPV is negative at - $2.4 billion, even taking into account that all
EX has already been spent. Therefore, except if the abandon option can be obtained for free, a
nal investor would rather pass. The expand option (Bonga SW-Aparo) considerably increase
verage NPV up to $7.3 billion, and is worth $6.8 billion. However, this move also increases
at 10% by 2.2 billion, reaching 8.2 billion. Still, the profit ratio stands at 1.61x, as the50
For the Bonga project, it seems really interesting to take a close look at the expand option (abo
Without flexibility, the average NPV is negative at - $2.4 billion, even taking into account tha
CAPEX has already been spent. Therefore, except if the abandon option can be obtained for fre
rational investor would rather pass. The expand option (Bonga SW-Aparo) considerably incr
the average NPV up to $7.3 billion, and is worth $6.8 billion. However, this move also incre
VaR at 10% by 2.2 billion, reaching 8.2 billion. Still, the profit ratio stands at 1.61x, as
expanded project has 2 chances out of 3 to create some value, as VaR = 0 at 33% (below).
To avoid such risk, an option
worth $16.4 billion is to delay
the expansion investment
until 2017. Altogether, the
three options are worth $26.1
billion, maximizing both the
average NPV and the profit
ratio, respectively up to $23.7
billion and 2.98x.
Bonga VaR – No flexibility VS Expand
Without flexibility, NPV is negative at - $2.4 bn, even taking into
account that all CAPEX has already been spent. Except if the
abandon option can be obtained for free, a rational investor would
rather pass. The expand option considerably increase the average
NPV up to $7.3 bn, and is worth $6.8 bn. This move also
increases VaR at 10% by 2.2 bn, reaching 8.2 bn. Still, the profit
ratio stands at 1.61x, as the expanded project has 2 chances out of
3 to create some value, as VaR = 0 at 33%
For the Bonga project, it seems really interesting to take a close look at the expand option (above)
Without flexibility, the average NPV is negative at - $2.4 billion, even taking into account that al
CAPEX has already been spent. Therefore, except if the abandon option can be obtained for free, a
rational investor would rather pass. The expand option (Bonga SW-Aparo) considerably increase
the Bonga project, it seems really interesting to take a close look at the expand option (above
hout flexibility, the average NPV is negative at - $2.4 billion, even taking into account that a

2.  Investment Recommendations
IV.2 Investment Recommendations
Majnoon: Invest without flexibility
Without any flexibility possible, the project is still highly profitable as its NPV = $133.0 billion.
Considering the size of such project, the initial CAPEX requirement is reasonable at $4 billion.
MAJNOON Conventional Land – without flexibility – Targets
CAPEX NPV objective VaR
(main, greenfield)
$4 billion
$133 billion No value at risk
West Qurna: Invest and buy the Expand option
The main project is profitable at NPV = $133.3 billion, although there is a massive initial CAPEX
required of $50 billion. The option to expand with West Qurna 2 is worth $62.5 billion, and it
should be seriously considered as the initial $25 billion CAPEX is lower than the option value.
WEST QURNA Conventional Land – with Expand option – Targets
$50 billion (main, greenfield)
+ $25 billion (expansion)
= $75 billion
$195.8 billion No value at risk
IV.2 Investment Recommendations
Majnoon: Invest without flexibility
Without any flexibility possible, the project is still highly profitable as its NPV = $133.0 billion.
Considering the size of such project, the initial CAPEX requirement is reasonable at $4 billion.
MAJNOON Conventional Land – without flexibility – Targets
(main, greenfield)
$4 billion
$133 billion No value at risk
West Qurna: Invest and buy the Expand option
The main project is profitable at NPV = $133.3 billion, although there is a massive initial CAPEX
required of $50 billion. The option to expand with West Qurna 2 is worth $62.5 billion, and it
should be seriously considered as the initial $25 billion CAPEX is lower than the option value.
WEST QURNA Conventional Land – with Expand option – Targets
= $75 billion

70
= $75 billion
ACG: Invest and buy the Abandon option
The main project without flexibility is profitable, NPV = $37.3 billion. All the CAPEX has already
been spent, so the buy-out price should be under that value to guarantee a return. For risk-averse
investors willing to avoid the value at risk at a 10% probability, the abandon option can be
considered if such option can be negotiated for less than its value of $1.53 billion. The expand
option should not be taken as the $6 billion initial CAPEX required exceeds the option value.
ACG Deepwater – with Abandon option – Targets
$0 - $34 billion (main, buy-out)
+ $0 - $1.4 billion (abandon option)
= $0 to $35.4 billion
$38.8 billion VaR = 0 at 5%
Bonga: Invest and buy the Delay, Expand and Abandon options
Without flexibility, the main project is not profitable as its NPV is negative (-$2.4 billion).
However, adding the three possible options, the project’s average NPV increases up to $23.7
billion. If the Bonga Southwest-Aparo expansion is delayed, the initial CAPEX required amounts
to $12 billion. The buyout of the main project should be obtained for free, the delay option would

$0 - $34 billion (main, buy-out)
+ $0 - $1.4 billion (abandon option)
Bonga: Invest and buy the Delay, Expand and Abandon options
Without flexibility, the main project is not profitable as its NPV is negative (-$2.4 billion).
However, adding the three possible options, the project’s average NPV increases up to $23.7
billion. If the Bonga Southwest-Aparo expansion is delayed, the initial CAPEX required amounts
to $12 billion. The buyout of the main project should be obtained for free, the delay option would
need to bring the remaining $3 billion CAPEX, the abandon option should be negotiated under its
value of $2.9 billion.
BONGA Deepwater – with Delay, Expand and Abandon options – Targets
$0 (main, buy-out)
+ $0 - $2.9 billion (abandon)
+ $12 billion (expand and delay)
Lula: Invest and buy the Delay, Expand and Abandon options
Without flexibility, the main project is profitable (NPV $69.1 billion) but risky as $35 billion and

71
+ $12 billion (expand and delay)
Lula: Invest and buy the Delay, Expand and Abandon options
Without flexibility, the main project is profitable (NPV $69.1 billion) but risky as $35 billion and
$9 billion are respectively at risk at a 10% and a 20% probability. Adding the three possible
options, the average NPV increases up to $111.6 billion. The expansion Lula South costs an initial
CAPEX of $3.7 billion, while the abandon and delay options should be negotiated contractually at
a cost lower than their estimated value.
LULA Deepwater – with Delay, Expand and Abandon options – Targets
$80 billion (main, greenfield) $111.6 billion No value at risk
+ $3.75 billion (expand)
+ $0 - $9.7 billion (delay)
= $83.75 to $99.35 billion

= $83.75 to $99.35 billion
Sakhalin: Invest and buy the Expand option
The main project is profitable, NPV = $137.5 billion, all the CAPEX has already been spent. The
expand option Sakhalin-3 worth $11.6 billion should be considered as the initial $5 billion CAPEX
is lower than the option value.
SAKHALIN LNG – with Expand option – Targets
$0 - $137.5 billion (main, buy-out)
+ $5 billion (expand)
= $5.0 to $142.5 billion
Yamal: Invest and buy the Delay option
The project is profitable, NPV = $47.2 billion, a massive $27 billion CAPEX is required. As the
first oil is planned for 2017, the delay option is extremely interesting and increases the NPV up to
$137.5 billion. The abandon option has no real interest as no project value is at risk here.
YAMAL LNG – with Delay option – Targets
= $27.0 to $117.3 billion
= $83.75 to $99.35 billion
Sakhalin: Invest and buy the Expand option
The main project is profitable, NPV = $137.5 billion, all the CAPEX has already been spent. The
expand option Sakhalin-3 worth $11.6 billion should be considered as the initial $5 billion CAPEX
is lower than the option value.
SAKHALIN LNG – with Expand option – Targets
+ $5 billion (expand)
= $5.0 to $142.5 billion
Yamal: Invest and buy the Delay option
The project is profitable, NPV = $47.2 billion, a massive $27 billion CAPEX is required. As the
first oil is planned for 2017, the delay option is extremely interesting and increases the NPV up to
$137.5 billion. The abandon option has no real interest as no project value is at risk here.
YAMAL LNG – with Delay option – Targets
= $27.0 to $117.3 billion
AOSP: Invest and buy the Abandon option

72
= $27.0 to $117.3 billion
AOSP: Invest and buy the Abandon option
The project is profitable, NPV = $25.0 billion, all CAPEX has already been spent. An abandon
option is worth $1.3 billion, and avoids $5 billion of project value to be at risk at a 10% probability.
AOSP Oil Sands – with Abandon option – Targets
$0 - $25 billion (buy-out)
Kearl Lake: Invest and buy the Expand option
With an average NPV = $35.4 billion, the main project is profitable and requires an initial CAPEX
of $11.1 billion. The expansion is highly recommended, as it costs a $8.9 billion CAPEX and
increases the value by $42.9 billion. The profit ratio with the expansion rises at 4.59x, up from
3.75x.
KEARL LAKE Oil Sands – with Expand option – Targets
$12.9 billion (main, greenfield)
= $21.8 billion
Snorre: Invest and buy the Abandon option
AOSP Oil Sands – with Abandon option – Targets
$0 - $25 billion (buy-out)
Kearl Lake: Invest and buy the Expand option
With an average NPV = $35.4 billion, the main project is profitable and requires an initial CAPEX
of $11.1 billion. The expansion is highly recommended, as it costs a $8.9 billion CAPEX and
increases the value by $42.9 billion. The profit ratio with the expansion rises at 4.59x, up from
3.75x.
KEARL LAKE Oil Sands – with Expand option – Targets
= $21.8 billion

73
= $21.8 billion
Without flexibility the main project is profitable as NPV = $3.3 billion, all CAPEX has already
been spent. The abandon option avoids $2 billion and $0.6 billion potential losses at respectively
10% and 20%. With such option, the VaR = 0 probability decreases from 26% to 5%. The
expansion is not advised as its cost, $7.16 billion, is way above its real option value, estimated at
$1.95 billion.
SNORRE EOR – with Expand option – Targets
Troll: Invest without flexibility
The NPV of the main project without flexibility is $30.5 billion, all CAPEX has already been spent.
As no value is at risk, the abandon option has no interest. The remaining expand option cannot be
considered, as it actually decreases the average project value by $1.1 billion and costs $1.7 billion
in CAPEX.
TROLL EOR – without flexibility – Targets
(main, buy-out)

3. Discussion
3.1. Price effect
The modelized oil price starts at the average 2013 value of $108.56, and follows a long-term upward trend
of +5% in average. As of December the 3rd, the current Brent oil price is around $70.
3.2. Discount rate
Is the discount rate sufficient to modelized the global risk of oil and gas operations in a high above-the-
ground risks country? What should be the discount rate for operations in Mauritania or Kurdistan?
3.3. Taxation
The government take is not a precise measure of the country oil and gas taxation level, as parallel tax
mechanisms may apply such as oil and gas VAT, expatriate workforce taxation, social and environmental
taxes, and “off-the-book” paybacks mechanisms.
3.4. Existence of delay options in JV and partnerships
How real is the possibility to delay investment when multiple partners are involved in the projects, as it is
often the case for megaprojects?
3.5. Microeconomics of oil and gas projects
Common industry constraints such as rig availability, access to infrastructures and skilled workforce, role
of management, right of the shareowners and market for natural gas, are not taken into in this study.

Conclusion
Main Research question:
Identifying and measuring real options helps to highlight the added value of flexibility of oil and gas
megaprojects. This can be done with simple models if in discrete time, things become a bit tougher if to
study American options in continuous time.
Secondary Research question:
The results can make a case for investment recommendations, although ideally we should know the level of
risk aversion and the cost of capital of the investor.
Of the interest to consider uncertainty in oil and gas megaprojects
At $108.6/bbl in average in 2013, most of these megaprojects were profitable, and real options could help
capture added value. At $70/bbl in average in early December 2014, most of the projects are priced out and
the few ones able to reach their break even point are the Iraqi conventional projects and the Azeri
deepwater project. Most expansions become unprofitable at such level of prices.
Considering buying contractual real options to avoid lock-in situations seems highly interesting indeed.

Thanks for your
attention !
Antoine Paillat
antoine.paillat@essca.eu
+(33) 636 359 212

Master Thesis - Real Option Valuation of oil and gas megaprojects

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