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Real options in oil and gas exploration

The basics

Oklahoma State University, Stillwater, U.S.

Rick Chimblo

R. D. Chimblo & Associates, Houston, Texas, U.S.

Corresponding author: ckchimblo@cox.net; oilman01@earthlink.net

The first 20% of the full text of this article appears below.

Exploration geophysicists and geologists are familiar with the process of risk assessment and economic evaluation of oil and gas prospects. Many asset teams are required to conduct individual portfolio management exercises when competing for company resources.

In the broader world of finance and economics, real options theory has developed into a sophisticated tool for evaluating and managing large investment portfolios of mixed assets with different risk characteristics. Although examples of option-based analysis have been documented in the oil and gas industry, many applications only address downstream operations. However, the influence and application of real options analysis throughout the entire E&P lifecycle has been limited.

Before accepting real options as a common practice in any oil and gas company, a better understanding of this technically demanding process must be achieved. Specifically, in upstream applications of real options, explorationists require a basic understanding of the principles of real option theory before they can add this tool to their arsenal of oil and gas investment evaluation.

	Introduction to real options

 
In the competitive and dynamically changing business environment, success is often measured by management's flexibility and ability to adapt to changes. However, traditional approaches to decision-making assume a static, and rather linear, decision-making process with fixed outcomes. Valuation methods that rely on discounted cash flow (DCF) series, such as net present value (NPV), do not capture all the intrinsic attributes of an investment opportunity.

Real options, as its name implies, uses the well-established rules of option theory to evaluate physical or real assets. For years the investment industry has used option theory to analyze financial assets or stocks and bonds. Only in the past decade has real options started to receive more general attention.

Unlike the traditional DCF approach, real options assume a dynamic series of future decisions, which provide flexibility to adapt to given changes in . . . [Full Text of this Article]