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OGEL Cover v1.3
Oil, Gas & Energy Law Intelligence
Valuation of Undeveloped Oil Reserves
with Option Pricing Model
by B. Lubiantara
Issue : Vol. 4 - issue 4
Valuation of Undeveloped Oil Reserves
With Option Pricing Model
Modern financial theories such as option theory are increasingly being used to evaluate the economic viability of oil and gas projects. The stimulus for the use of this approach is the limitations of Discounted Cash Flow (DCF) methods such as NPV and IRR. These methods assume that the project is of a “now or never” nature. In fact, this is not the case; as an investor, one has many choices, such as to defer the project if it is not seen as being economically viable. One can also choose to expand or increase production capacity if the price of the commodity rises. The DCF method often condemns a project as being “uneconomical” simply because it does not take into consideration such flexibility. Logically, the existence of such options or flexibility should add to the project’s value.
This paper will discuss how the option approach that is usually used in modern financial management theory can be applied to the evaluation of undeveloped reserves. Option is a right, not an obligation. Options have similarities to projects involving mineral reserves. As an Investor, one has the right to develop the reserves; on the other hand, if economic conditions are not conducive, one has the option to postpone the project. This paper will explain how to evaluate the economic viability of an oil reserve that has not been developed (an undeveloped reserve) on the basis of the perspective of Option theory; the method that will be used is one of the better known methods of option pricing theory, the Binomial Tree. Introduction
Decision making in Corporate Investment has always been a difficult undertaking for analysts. Traditionally, NPV and Decision Trees have been the fundamental tools for modeling investment opportunities. Recently, there has been a growing interest in financial Option Pricing Models (OPM) in the corporate investment domain. The value of flexibility under uncertainties has been realized long back. Decision trees were the only available tools to...