Burns is manager of
acquisitions and evaluations with Dominion Exploration Canada, Calgary.
prospectors and engineers routinely assess the monetary value of
any proposed E&P venture
by building a business model of the project over its projected life,
using volumes and rates consistent with the geotechnical data, and
costs and prices that are consistent with experience and credible
forecasts. We call such an analysis a Discounted Cash Flow (DCF)
Model, and its ultimate aim is to express the Net Present Value
(NPV) of the project, implicitly taking into account the time value
conventional DCF analyses seem to be inadequate:
- They seem
to undervalue large, long-term projects (the kinds that build
- They don't
handle multiple uncertainties well.
- They don't
facilitate consideration of alternative scenarios.
This has led
to consideration of another way of evaluating E&P projects --
Real Options theory and methods.
The basic concept
of Real Options is this: The very fact that you own (or could own)
an asset itself provides other business opportunities that can add
value -- in other words, there is implicit value in having business
epigram conveys the thought: "It takes money to make money."
In this column,
James Burns writes about Real Options. His essay will start this
month and conclude in the April issue.
concept that there is economic value in business flexibility is
It is also
obvious that petroleum exploration is an activity where large amounts
of capital are invested in projects with the expectation of receiving
highly uncertain financial returns over extended periods of time.
As Pete Rose has eloquently discussed in this column and elsewhere,
petroleum E&P in aggregate has not generated acceptable returns
for some time.
thinking companies are applying numerous techniques to improve their
performance -- including comprehensive technical risk assessment,
decision analysis, portfolio management and real option analysis.
to delay, accelerate or alter capital investments as competitive
conditions change, uncertainties resolve and product prices develop,
the ability of management to change strategies, execute risk-modifying
contracts (e.g. farm-ins, farm-outs, joint ventures, hedges, etc.)
and take other actions, all have value that is difficult to capture
without the real options approach.
theory to allow the valuation of financial option contracts was
not developed until the early 1970s, when papers published by Fischer
Black, Myron Scholes and Robert Merton led to a revolution in financial
economics and a transformation of risk assessment in financial markets.
Almost immediately, academics and practitioners alike noted the
option-like characteristics of investments in risky assets (real
ensuing years a vast accumulation of academic papers developed a
clear theoretical basis for valuing real options.
provides the right -- but not the obligation -- to undertake an
action of some sort (buy or sell, invest or don't invest, etc.)
under prescribed terms within a prescribed time period.
consider the decision to acquire a lease: This provides a series
of options to further evaluate the potential of the lease (e.g.
seismic), leading to the option to drill an exploratory well. If
successful, the well creates an option to develop the discovered
field and realize cash flows from the ensuing production.
method of valuing such investments is to:
- Estimate the cash
flows over the range of possible reserve sizes that may be discovered
(and the consequential productive field life).
- Discount the mean
cash flow at an "appropriate" discount rate.
- Compare the value
times the chance of successfully developing the project with the
chance-weighted cost of failure.
several shortcomings in this approach:
- It expresses a static
set of events, whereas there are numerous opportunities to walk
away from, or modify the project as further evaluation is completed.
- Expected value calculations
or decision tree evaluations often include the cost of sub-economic
discoveries in the roll-up, which ignores the fact that no company
will knowingly undertake a large investment in a non-economic
- As further evaluation
is carried out, the inherent risk of the project changes dramatically;
this reduction of risk, as uncertainty is resolved, is very difficult
to capture using traditional methods such as decision tree analysis,
and can have significant impact on the value.
- How to establish
and specify risk-adjusted discount rates.
- It is difficult to
evaluate the ability to defer investment until oil or gas prices
reach appropriate levels and, if necessary, be locked in to futures
markets or other derivative contracts in order to guarantee a
the ability to model changing economic conditions in a dynamic competitive
environment -- and the value of various management strategies to
respond to such changes -- is the key advantage of real option methods.
A particularly good
book on economic assessment of E&P ventures is by Frank and
John Stermole, "Economic Evaluations and Investment Decision Methods,"
published by Investment Evaluations Corp., 2000 Goldenvue Drive,
Golden, Colo. 80401.