Oil field valuation - a real option based analysis

Abstract

In today’s world, every major decision, whether economic, political, or even social, takes into consideration crude oil prices. Oil has become such an important word in today’s scenario that naming it as “most talked about thing of the century” wouldn’t be an exaggeration. In such a hyped up (and heated one, also) atmosphere, oil field valuations are increasingly assuming importance. The scrambling of companies to acquire oil fields at a frantic pace is probably leading to over valuations and distortion of fundamentals. There are various approaches available for valuation of oil fields, including the DCF approach but there are certain fundamental problems due to which one needs to look to another methodology for correct valuation. Option world provides such an alternative with real option valuation models constantly being developed for natural resources, and especially for oil. We have implemented one such model to gain a better understanding of effects of various changes of parameters on valuation and analyze recent trends in reallife valuations of oil fields. The model splits the valuation of the oil field into three stages 1. Production stage 2. Development stage 3. Pre development stage wherein one has an option to start development of the oil field within a fixed time frame Then a combination of stochastic calculus and numerical modeling is used to obtain the value of the oil field starting from the third stage onwards till the first stage. In the first stage, the real option features of abandonment option and option of early exercise , embedded in the oil field, are incorporated in the model. The model is used to analyze an illustrative example to understand the evolution of an oil field value through the three stages. Theoretical frameworks are used to understand this evolution. Analysis has also been done of the impact of varying two key parameters of the model on the valuation results. In the last section, valuation of two actual oil fields, the Sakhalin-I oil field in Russia and the Atlantis oil field in USA, have been done. It is observed in both cases that the two oil field values have limited dependency on spot value of oil and the time left to the expiry of the development option. Moreover both have an extremely low critical spot price (Spot price above which it immediate exercise of the option is mandated) compared to the long term average oil price. All these aspects are identified to be a result of the relatively long operational life of the two oil fields which limits the impact of near time factors. This model, in its current shape, can be used for the valuation of oil fields subject to the assumptions of a relatively rigid operational cash flow structure. It enables one to chart the evolution of the oil field value over the three stages and study the impact of changes in different parameter values. Looking forward, the rigidities in the model in terms of constant oil production each year, capital expenses as a linear function of oil production etc. can be relaxed to make the model more generic in nature. Moreover, the whole model can be automated and packaged as user friendly software to promote higher levels user acceptance.