Valuation of Government Incentives for Hydrocarbon Asset Developments - A Real Option Approach

Aliaga, Wilson (Petrobras America Inc)



In recent years, the Oil & Gas industry has struggled due to the low hydrocarbon prices. In this context, E&P firms have responded by optimizing their asset portfolio with focus on prospects with the lowest possible financial and technical risks. Since this process has seriously affected countries with emerging hydrocarbon plays and/or relatively low explored geology, government incentives play a pivotal role to mitigate this pessimistic trend. To understand their benefits, this paper presents a methodology to value hydrocarbon prospects using a real option formulation that properly incorporates government incentives such as royalty relief and royalty rate structures that vary with production volumes and prices.

This work links valuation and incentives by using functions that depends linearly on relieved and produced volumes and non-linearly on price. These variable royalty schemes behave similar to bull spreads (financial derivative tool), limiting the upside and downside risk of both government and company take due to hydrocarbon prices and production volumes. Then, we incorporate these functions into the general real option formulation and numerically solve the yielded equations using finite differences methods.

For illustration purposes, the proposed approach is applied to a hypothetical field with an exponential decay production curve. We compare the impact of government incentives for both the prospect value and the optimal investment rule. As observed, these incentives have two merits: to positively influence the economic attractiveness of future developments by compensating investors for their high-risk exposure and to allow an optimal government take in an unfavorable price environment.

We observed that before lease expiration, the real option approach assesses the timing option. Consequently, this approach yields higher values than the NPV analysis since delaying the project execution can be more valuable than the immediate option exercise. Moreover, depending on the financial and volume parameters, intermediate waiting areas might appear between exercise regions. Hence, the methodology proposed captures not only the flexibilities available for an E&P firm that holds a lease, but also the economic benefit of the incentives and their impact on the investment rule.

In summary, the novelty of this work is to propose a general methodology that includes government incentives in the economic analysis of hydrocarbon asset developments using real options. This methodology captures the flexibilities available for managers to respond to hydrocarbon price uncertainty. Moreover, we also propose a new royalty rate scheme that resembles bull spreads. This scheme allows investors to capture the upside of production and prices, and optimizes the government take.