Applying Real Options Valuation in the Concept Selection Phase of Petroleum Projects
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In this thesis we consider the problem of choosing among mutually exclusive investments in the petroleum industry. More specifically, we look at the concept selection phase, which involves choosing an installation for an oil field. The most important factors that need to be taken into account when making the concept decision is the future oil price and the expected reservoir volume. As there is flexibility regarding the timing and the type of concept, one should use a valuation method that takes into account the dynamic nature of decision making and uncertainty. We will therefore apply a real options approach. We consider a case study proposed by the Norwegian petroleum firm Det norske oljeselskap ASA. They are currently evaluating two potential concepts for a recently explored field in the North Sea. Within three years, the company needs to make the final concept decision. Otherwise, the licence for developing the field must be delivered back to the Norwegian government. We propose two models that derive the value of the option to invest, as well as an optimal investment policy that depends on the realised oil price, the expected reservoir volume and the time left until deadline. The optimal investment policy shows the price thresholds for which it is optimal to invest in either of the concepts. We also find intermediate inaction regions between the price thresholds for the two concepts where it is optimal to not invest in either concepts, but rather wait. We first introduce a model that takes oil price uncertainty into account. This model is then extended to include uncertainty in reservoir volume. We apply a binomial lattice valuation, which is a numerical approach that applies risk-neutral pricing. Our results show that there is a great value of waiting, and that the oil price must be very high to justify early exercise. Further, we find that when taking uncertainty in reservoir volume into consideration, the project value increases and the optimal investment policy is affected. With higher uncertainty it is more valuable to wait for information, and thus the region in which it is optimal to postpone the concept decision expands. The purpose of our cooperation with Det norske oljeselskap ASA is to present a practical valuation tool that can be used for similar investment decisions in the future. Therefore, we thoroughly present how to fit an actual case study into the framework of real options valuation. Existing literature focuses on applying real options methods in the petroleum industry, but many of the resulting models appear too complex and sophisticated to be applied to real life projects. We therefore contribute to the literature by introducing an approach that is suitable for implementation in practice.