Real Options in the Petroleum Industry:A Critical Analysis
Engineering Honours Degree 2008
University of Adelaide
Economic analysis of projects is of paramount importance to the petroleum industry, perhaps more so than any other. Long-term investments are required into assets riddled with uncertainty and must be carefully considered, as they are more often than not irreversible. Discounted cash flow analysis has been the financial tool of choice for the last fifty years in valuing projects but has always lacked the ability to capture the value of the flexibility managers have in their investment strategies.
Real Options Analysis (ROA) is a powerful tool that has been developed over the last two decades and applied in capturing managerial and technological flexibility. The ROA revolution began shortly after the advent of Black, Scholes and Merton’s Nobel Prize winning breakthrough in financial options valuing. Since then it has been recognised that Black-Scholes is too simple to appropriately value early exercise and multiple dividend paying options. Finite difference approximation of the Black-Scholes model has proved a legitimate alternative but the most promising technique to date is the Least-Squares Monte Carlo simulation.
The future of Real Options Analysis lies in refining the modeling techniques that have been suggested and testing them empirically. The expected values suggested by options valuation theory are unlikely to be accepted by practitioners without evidence of their use in real world applications. Valuing the flexibility of past projects to compare them with actual outcomes will provide immediate qualitative and quantitative results regarding the validity of the ROA approach.