Valuing an offshore oil exploration and production project through real options analysis

To be useful to project managers, real option analysis (ROA) needs to capture the unique characteristics of individual projects and, at the same time, remain tractable and intuitive. That is a challenge since actual projects are often complex, featuring multiple sources of uncertainty as well as multiple investment and operating options. To meet the challenge, ROA has to take a clinical approach to project management and valuation, tailoring its framework to the specifics of each individual project to reflect its main sources of flexibility without becoming overly complex. This paper undertakes a ROA of an offshore oil development project of an integrated oil and gas company. The sequence and interconnections of available real options - exploration options, appraisal options, scaling options and abandonment options - as well as the calibration of the model's parameters, are developed in close collaboration with the Exploration and Production (E&P) division of the company, to assure realism and adherence to what management believes are the key sources of investment flexibility in a typical offshore project. The project assumes that there is joint uncertainty about reserve size and the price of oil. While the first source of uncertainty is resolved through exploration and appraisal activities the second is resolved through a diffusion model. The available real options add a substantial value to the project, with the option to abandon being the most valuable.