1. REAL OPTIONS ANALYSIS OF MARGINAL OILFIELD
DEVELOPMENT PROJECTS: THE CASE OF THE UKCS
By: Theophilus Acheampong
MSc (Econ) in International Business, Energy & Petroleum
December, 2010

2. OVERVIEW
 Origins: Management flexibility
 Understanding the concept
─ The Real Options Approach to Investment
─ Real Options and Total Value
─ E&P as a Sequential Real Options Process
 Case Study
─ Assumptions
─ Methodology
─ Results
 Summary and Conclusions
 Appendix
Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum
University of Aberdeen, Aberdeen, U.K.

3. Origins: Management flexibility
 Many oilfield development projects are not static, they involve varying degrees of
risks and uncertainties. There are:
― Geo-technical Risks e.g. Petroleum Reserves Risks
― Market & Macroeconomic Risks (e.g. oil prices, inflation and discount rates)
 How does management remain flexible in the midst of these uncertainties?
 A modular development plan based on these unexpected events is what is needed.
 Management can modular these development projects for example by waiting,
expanding, contracting and abandoning.
 This flexibility has value and capturing this value is what Real Options Analysis
(ROA) entails
Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum
University of Aberdeen, Aberdeen, U.K.

4. Understanding The Concept 1: The Real Options Approach to Investment
 ROA is a modern methodology for economic evaluation of projects and investment
decisions under uncertainty
 It complements (not substitutes) the corporate tools as yet.
 ROA can be viewed as an optimization problem:
 Maximize the NPV (the objective function) subject to:
― Market uncertainties (eg.: oil price);
― Technical uncertainties (eg., oil in place volume); and
― Relevant Options (managerial flexibilities)
 ROA considers the uncertainties and the options thus answeing 2 questions:
 What is the value of the investment opportunity (value of the option)?; and
 What is the optimal decision rule (threshold)?
 ROA is the Application of Financial Option Valuation Techniques to Business Assets
Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum
University of Aberdeen, Aberdeen, U.K.

5. Understanding The Concept 2 : The “Total Value” Approach
Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum
University of Aberdeen, Aberdeen, U.K.

6. Understanding The Concept 3: Decision Tree Analysis & Real Options
Preserve Field
High Probability, λ
Develop Field
Low Probability, (1-λ)
Oilfield Investment
Preserve Field
High Probability, λ
Develop Field
Preserve Field
Low Probability, (1-λ)
Develop Field
Work Backwards
Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum
University of Aberdeen, Aberdeen, U.K.

7. Understanding The Concept 4 : (E&P as a Sequential Real Options Process)
Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum
University of Aberdeen, Aberdeen, U.K.

8. Case Study 1
 The project was aimed at:
― Making an analysis of the DCF valuation methodologies vis-à-vis ROA
― The ROA looked at the flexibility value of Deferral, Abandonment, and
Expansion Options during the relinquishment requirement period
 A sample undeveloped marginal oilfield in the UKCS was utilized for this study
 Marginal oilfields may prove uneconomic when developed under current
circumstances.
 This was chosen to highlight the significance of risks to the valuation method
employed and the strategic importance of these options
 The methodology for the study comprised of capital budgeting using the DCF via
the Net Present Value(NPV)
 For the ROA via the option pricing models (i.e. Black-Scholes and Binomial Lattice
Models).
Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum
University of Aberdeen, Aberdeen, U.K.

9. Case Study 2: Methodology
Deferral Option
Fig 1: Valuation Methodology Summary
Model
Option Valuation Expansion Option
Key Input Data Base NPV Model Parameters Model
Abandonment Option
Model
Option Valuation
Key Input Data DCF Base Model Embedded Project Options
Parameters
• Revenues - Oil prices and • Cash Flows – Pre and Post • Identify and model project • Deferral Option Base Value
Production volumes Tax Basis uncertainties and Sensitivity Analysis
• Estimate project
• Costs - Tariffs, • Base NPV, IRR, Payback volatilities using MC • Expansion Option Base
Development and Period Profitability Index Simulation Value and Sensitivity
Operating expenditures Analysis
• Calculate the other 5
• DCF Sensitivity Analysis –
determinants of the • Abandonment Option
• Other data - such as the e.g. Monte Carlo
option value (e.g. strike Base Value and Sensitivity
UK Fiscal Terms and Simulation
price) Analysis
Discount Rate (Cost of
Capital) • Estimate option values
using opting pricing
methods (e.g. Binomial
Lattice)

10. Case Study 3: Main Results
PROJECT PROFITABILITY METRICS
Base Case NPV NPV $M 262.30
Note: Expanded
IRR 65.7%
NPV = Base NPV
Profitability Index 1.23 + Option Value
Real Options Analysis Values Deferral Option $M 317.21
(Expanded NPV) Expansion Option $M 270.13
Abandonment Option $M 262.31
400
350 317.21
300 262.30 270.13
Values ($ million)
262.30 262.31
250 262.30 Project Values with
200 Flexibility (Base
Case Scenario)
150
100
50
-
Deferral Option
Expansion Option
Real Options Analyis Value
Abandonment Option
Static NPV
Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum
University of Aberdeen, Aberdeen, U.K.

11. Summary & Conclusions
 Real Options Analysis is an important step beyond DCF.
 It is a powerful tool in project evaluation as it views projects as options to react to
unfolding uncertainties.
 ROA allows to us calculate the value of future flexibility. The total value of an
investment is an important key stone for strategic decisions.
 The results indicate that the value of the oilfield can be significantly improved by
considering the flexibilities indicated by the embedded options
 For example, using the options approach by incorporating a Deferment Option, the
project value is 20.5% greater the static DCF value.
 ROA presents advantages over the DCF valuation because:
 It creates the opportunity to maximize the upside potential and lower the
downside risks.
 It accurately accounts for the project value
Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum
University of Aberdeen, Aberdeen, U.K.

12. Thank You:
Questions?

13. APPENDIX
Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum
University of Aberdeen, Aberdeen, U.K.

14. Classical Model of Real Options in Petroleum
 Paddock & Siegel & Smith (1987-88) wrote a series of papers on valuation of
offshore reserves.
 It is the best known model for oilfields development decisions
 It explores the analogy financial options with real options
Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum
University of Aberdeen, Aberdeen, U.K.

15. Option Calculation
Simulation Continuous Discrete
Monte Carlo Simulation Black/Scholes & Derivatives Binomial Trees
+ Easy to understand + Mathematically elegant + Easy to understand
+ Applicable to all Real Options
+ Applicable to all Real + Relatively easy to calculate manually constructs
Options constructs
+ Simple Real Options
modelling
+ Fast calculation
− Very laborious − Complex to very complex − Very laborious
implementation implementation with Excel
− Hard to understand for practitioners
− Slow calculation
− Limited applicability − Interpretation of results not
− Delicate issues in valuation very intuitive
of Real Options
(correlations, probabilities)
etc)
Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum
University of Aberdeen, Aberdeen, U.K.

16. Spreadsheet Samples: NPV Analysis

17. Spreadsheet Samples: Deferral Option Analysis

18. Some Important Scientific Foundations of Real Options
Theophilus Acheampong, MSc (Econ) International Business, Energy & Petroleum
University of Aberdeen, Aberdeen, U.K.