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Abstract. The results from the Discounted Cash Flow (DCF) are limited as a tool for decision-making in the petroleum industry because they don't properly take into account four important features of the modern investments: uncertainty, irreversibility, timing, and corporation's risk-aversion. Recent developments in real options and preference theories have allowed decision-makers to employ these two approaches separately in the process of valuation and decision-making of risky projects. This paper presents a model for valuation and decision-making integrating discounted cash flow, real options and preference theory and aims at answering the following questions:What is the current value of an oil project? What is the optimal working interest in this project venture? What are the criteria to select projects considering investment irreversibility, uncertainty and timing to implement decisions? This model is applied to valuation and decision-making of a project to produce oil from a deep-water reservoir and its results are compared to those of the traditional approach. Traditional model suggests that, as the project value is above its investment cost, the corporation should invest immediately and incur in 100% working interest. Contrarily, for an specific analysis, the integrated model suggest the corporation should invest as long as project current value is as large as 1.85 times investment cost and should take only 44.38% working interest, whereas partners fund and acquire the remaining 55.62% of the project. In general, results indicate that NPV tends to pay more attention on return and does not account properly for risk. Then, as the uncertainty (volatility) of strategic variables increase, the two models give more divergent results. Key-words: uncertainty, real options, capital budgeting, preference theory. 1. INTRODUCTION Capital budgeting in the oil and gas business has the feature of potential to huge gains but also potential to huge losses (risk). In addition, unrecoverable investments in a single development phase to produce an oil field may reach amounts of billion dollars. In this context, Dixit & Pindyck1 and Lima2 pointed out that a model for investment valuation and decision-making must take into account four important characteristics: i) Uncertainty over the future operational cash flow; ii) Irreversibility of the investment; iii) Value of the timing or some leeway to implement decisions, and iv) Risk aversion of corporations. The irreversibility of investment is the main parameter of concern. For example, consider an investment of US$100 million in a risky oil project. If the budget of corporation is as high as US$1 billion, this risk investment can be tolerated. On the other hand, if the budget of corporation is only US$300 million, managers can reject this risk project, because irreversible investment is too high compared to the new budget of the corporation. In this context, depending on the magnitude of investment, under unsuccessful results the corporation may face serious financial impacts. As a result, the irreversibility of investment is one the main driving-force of investor's risk aversion behavior Why investment irreversibility tends to lead investor's behavior towards a risk-aversion attitude? The answers are closely related to project value volatility derived from geological, technical, economical, and financial uncertainties. Theses uncertainties imply in oscillations of the project value over the time, giving rise to potential positive and negative outcomes. A positive outcome generates an upside potential for profits and may aggregate value to project. On the other hand, a negative outcome may imply in a partial or total loss of the irreversible investment. By letting the effects of uncertainty freely, from the viewpoint of a passive management, the outcome of a project (NPV) tends to be like symmetrical a distribution.
- North America > United States > Texas > Kleberg County (0.24)
- North America > United States > Texas > Chambers County (0.24)
Abstract The volatility is a key parameter that is difficult to estimate, but has a major influence in economic evaluation. Under the traditional investment view, volatility increases project risk, and the discount rate via a higher risk premium. In investment decision under the real option theory, volatility may aggregate value to the project, since the downside potential is limited whereas the upside is theoretically unbounded. In addition, volatility is an important indicator in oil project risk management, especially when oil prices present high levels of fluctuation. Volatility is hard to estimate. Oil price volatility can be estimated using historical data, but the procedure for estimating project volatility is more complex. This paper presents a framework to estimate the volatility of oil production projects employing a numerical technique based on project cash flows and the simulation of the evolution of oil prices using the Monte Carlo technique. Three stochastic processes to track oil price dynamics were used: Geometric Brownian Motion, Mean Reversion, and a pure Independent Lognormal Model. Since price is uncertain, NPV will also be an uncertain variable, so that its standard deviation is used as estimation of the true project volatility. This approach is applied to a portfolio composed of 12 deep-waters oil projects located in offshore Brazilian basins. These projects have different characteristics in terms of oil quality, water-depths, CAPEX, OPEX, infrastructure, etc. In order to reveal differences in results of project volatility, several correlations were evaluated regarding CAPEX, oil price and volatility of oil price. Preliminary results indicate that the project volatility is equal or higher than that of oil prices, especially in the case of high CAPEX and low price. In the simulations used in this study, project volatility ranged from 1 to 3 times oil price volatility. In case of oil volume of less than 300 MM bbl, the project volatility is around 1.8 times that of crude oil spot price. Therefore, this paper shows that the traditional assumption of using the oil price volatility, as a proxy for the project volatility may not give realistic results since most projects may not present a linear relationship between long-run average price and OPEX. Key-words: uncertainty, real options, volatility, capital budgeting. Introduction Future volatility of the underlying asset is one of the most important inputs in the real options model of valuation and decision, but this parameter cannot be easily observed in the market. One of the main difficulties is the availability of the historical time series of project market values, especially when valuing the option to invest, since in this case the potential project does not yet exist. Davis[1] pointed out that if the potential project is identical to others owned and operated by listed companies, it may be possible to estimate the rate of volatility of the project's value from a historical series of company values. If there are options on these listed companies, an implied volatility could also be estimated[2]. In another attempt Pickles and Smith[3] model de value of developed oil reserves by using reported reserves transactions values, finding a reserve's value volatility value of 0.23 very close to volatility of crude oil prices of 0.22. However, the authors pointed out this methodology cannot be a general rule for all oil projects.For example, Dixit and Pindyck[4] recommend an annual volatility between 15% and 25%. Some authors (e.g. Baker et al.[5]) used an annual volatility value higher than 30%. These constraints force the real options practitioners to adopt informed guesses about the project's volatility from market information. Several authors[6] recognized that miss-estimation of the project's volatility may have important impacts on the estimated option value.