Modeling Choices of our Real Options Model

As we have seen so far, there is no single way to formulate a real options problem.

Therefore, this section is set out to explain the key modeling choices of our Real Option Model. Our model is based on a contingent claims analysis approach. Further, we model an abandonment option as an American put option. Finally, we apply a binominal lattice with risk-neutral probabilities in order to solve for the project value with flexibility.

The modeling decisions are based on three criteria we believe are important for our particular application.

1) Capture the decommissioning problem

First of all, we would like the Real Option Model to be able to capture the complex decommissioning problem. A typical late-life petroleum asset will experience negative cash flows when costs surpass the declining revenues. The model therefore needs to be able to manage a scenario where negative cash flows occur. Nonetheless, we are willing to make simplifications in order to keep the method intuitive. In other words, we accept that our model will not represent reality completely, as it never will.

To be able to model reality in the best possible way we first need to identify the type of problem we are analyzing. The option to abandon an oilfield is believed to have the same properties as an American put option. The decommissioning cost represents the exercise price of the option. The expiration of the option represents the potential life of the project.

The life of the project is limited as it is likely that the production license expires at some point in time or that the equipment deteriorates such that investments must be made in order to continue production. In addition, it is likely that the company is able to abandon the field at any time during project life (making it an American option as opposed to an European option). This would however include a response time, lasting from the time the abandonment decision is made until the decommissioning process is initiated, which needs to be incorporated in the model.

2) Take advantage of available information

We believe it to be advantageous to apply a real options method in which we are able to best utilize the information at hand. A distinctive feature of the oil and gas industry relative to other industries is that the production outcome, the crude oil and natural gas, are widely traded products in relatively efficient markets (Kristoufek & Vosvrda, 2014). These

commodity markets make it possible to retrieve information on historical and expected future prices. On the other hand, we are not provided with information on the underlying factors used in the estimation of cash flows. It is therefore hard to obtain any probabilities of the various outcomes of the project.

For this reason, a contingent claims approach is chosen over dynamic programming. The contingent claims approach actively applies the readily available market data. The approach is therefore frequently chosen for valuing petroleum projects (see for instance Ekern, 1988;

Pickles & Smith, 1993; Smit, 1997).

3) Intuitive, comprehensible and possible to communicate

As we are evaluating the potential of applying real options analysis for abandonment decisions at Statoil, we will argue that it is of great importance that the method is intuitive, comprehensible and possible to communicate. It is important that project analysts understand how to implement the method, and that they are able to communicate it to senior management. Keeping in mind that management might be completely unfamiliar with real options, we believe this to be an important consideration. In our opinion, the approach will only be of value if the decision-makers accept it.

The Real Option Model is thus formulated in a relatively simple manner, using a binominal lattice. Binominal lattices posses the advantage of being straightforward to illustrate graphically. In addition, solving a binominal lattice only requires basic algebra. A differential equation on the other hand, requires sophisticated mathematics rarely used in practice in the industry. A simulation solution method would require computations through Monte Carlo software, hence making the results less transparent.

Concluding Remarks

This chapter provides an overview of two financial frameworks for project valuation: the net present value framework and the real options framework. The NPV method involves computing a project’s expected future cash flows and then discounting these cash flows at a risk-adjusted rate. The risk-adjusted rate should reflect the time-value of money and the riskiness of the project. The Real Option Model is somewhat harder to summarize briefly, but typically involves the modeling of a project’s future cash flows as a function of some

“state variable” that is assumed to evolve randomly over time. Project value can for instance be found through the use of risk-neutral probabilities, but there exist several practical solution methods for solving a real options problem.

A great variety of modeling approaches and implementation difficulties might explain why the real options framework is less frequently applied compared to the NPV framework.

Implementing a real options model requires some modeling choices depending on the problem at hand. The final section of the chapter explains the modeling choices of our real options analysis.

5 Litterature review: Optimal Abandonment Timing