A Step-by-Step Approach to Improving
Investment Decisions and Asset Valuation
Real Options in Exploration & Production of Petroleum
Real Option Valuation (ROV) Conference
Maximize Return & Minimize Risk in Strategic Investments
New Orleans, March 21, 2000
By: Marco Antônio Guimarães Dias
Petrobras, Brazil
Main Real Options and Examples
Option to Delay (Timing Option)
 Wait,
see, learn before invest
 Oilfield development; Wildcat drilling
Abandonment Option
 Managers are not obligated to continue a

business plan if it becomes unprofitable
Sequential appraisal program can be abandoned
earlier if information generated is not favorable
Option to Expand the Production

Depending of market scenario and the
petroleum reservoir behavior, new wells
can be added to the production system
Options in Exploration & Production (E&P)
Oil/Gas
Success
Probability = p
Expected Volume
of Reserves = B
Revised
Volume = B’
 Tract (lease): Option to Explore (wildcat)
Wildcat
Investment
 Undelineated Field: Option to Appraise
Appraisal
Investment
 Delineated but Undeveloped Reserves:
Option to Develop ( to Produce )
Development
Investment
 Developed Reserves: Options of Expanding,
Temporary Stopping , and Abandonment.
Types of Uncertainties in E&P
 Exploration & Production of petroleum is subject to
all types of uncertainties. For investment decisions and
valuation purposes, the main types of uncertainty are:
 Technical Uncertainty: about the existence, the size,
and the economic quality of the reserves.
E&P technology
in ultra deppwaters is another example.
This uncertainty is solved by a step-by-step investment:
sequential real options with option to abandon
 Economic/Market
Uncertainty: about prices and costs
Oil
prices oscillations: are mean-reverting with jumps?
Market volatility incentives to wait until the project to
become “deep-in-the money”: optimal exercise of the option
 Strategic
Uncertainty: on the other firms behavior
Option-Games: drilling games
(Dias, 1997); OPEC games
Deepwaters Technology: Step-by-Step
New discoveries of large petroleum reserves has
been finding in deepwaters and ultra-deepwaters
Deepwaters
is the present and the future in oil exploration
The conquest of deepwaters in offshore Brazil is
a good example of the step-by-step approach
 In
the 80´s, diverless technology reaching 500 meters;
 In the 90´s, diverless and guidelineless technology
reached 1,853 meters (6,079 ft) (Roncador, 1999);
 Petrobras and others are developing technology for
up 3,000 meters. Companhies with technology have
the option to enter in deepwaters prospects
 The technology development for one deepwater oilfield
gives a real option to develop other deepwaters oilfields
 The technology valuation must consider the real options
that it creates, not only the immediate application
Deepwaters Technology: A Success History
 Most of deepwaters world records occurred in Campos Basin, Brazil
CONOCO
1 9 77
En ch o va
EN -1-R JS
124 m
1979
B o n it o
R J S -3 9
189 m
1 98 3
P ira ú n a
R J S - 23 2
1985
29 3m
M a ri m bá
R J S - 28 4
19 88
38 3m
M ar i m bá
R J S -3 7 6 D
4 92 m
1989
Jo l l ie t
53 6m
1 99 2
M a rl im
M R L- 9
19 94
781m
A u ge r
87 2m
1996
M a rs
89 6m
1994
M A R L IM
M R L- 4
10 27 m
M en s a
1 61 5m
19 97
M A R L I M SO UT H
M LS -3
17 09 m
RO N CA D OR
R J S-4 3 6
1 85 3m
G1990
WATER DEPTH WORLD RECORDS
1977 - 1999
Technical Uncertainty
 Technical uncertainty decreases as the investment in
information is performed (step-by-step approach).
 Geological uncertainty is reduced by the investment of
the whole industry in a basin

The “cone of uncertainty” (Amram & Kulatilaka) can be
adapted to the technical uncertainty understanding:
Expected
Value
confidence
interval
Higher
Risk
Current
project
evaluation
(t=0)
Lower
Risk
Lack of Knowledge Trunk of Cone
Risk reduction by the
investment in information
of all firms in the basin
(driver is the investment, not
directly by the passage of time)
Expected
Value
Project
evaluation
with additional
information
(t = T)
Technical Uncertainty
 But in addition to the risk reduction process, there is
another important issue: revelation of the true value

The expected value after the investment in information
can be very different of the initial estimative
Investment
in information reveals good or bad news
t=T
Value with
good revelation
Value with
neutral revelation
Current
project
evaluation
(t=0)
Value with
bad revelation
Investment in
Information
Project value
after investment
Technical Uncertainty
 The number of possible scenarios to be revealed is
proportional to the cumulative investment in information

Information can be costly (our investment) and/or free, from the
other firms investment (free-rider)
Investment
in information
(wildcat drilling, etc.)
.
t=0
Today
technical
and economic
valuation
Investment in information
(costly and free-rider)
t=T
t=1
Possible scenarios
after the information
arrived during the
first year of option term
Possible
scenarios
after the
information
arrived
during the
option lease
term
 The arrival of information process leverage the option value of a tract
E&P Process and Options
Oil/Gas Success
Probability = p
 Drill the wildcat (pioneer)? Wait? Extend?
Expected Volume
of Reserves = B
 Revelation: additional waiting incentives
Revised
Volume = B’
 Appraisal phase: delineation of reserves
 Technical uncertainty: sequential options
 Delineated but Undeveloped Reserves.
 Develop? “Wait and See” for better
conditions? Extend the option?
 Developed Reserves.
 Expand the production?
Stop Temporally? Abandon?
Valuation of Exploratory Prospect
 Suppose the case below: how valuable is this prospect?
 Suppose that the firm has 5 years option to drill the wildcat
 Other firm wants to buy the rights of the tract. Do you sell?
How valuable is the prospect?
“Compact Decision-Tree”
150 MM barrels
(expected reserve)
20 MM$
(wildcat)
Dry Hole
Valuation of Exploratory Prospect
 The traditional method looks only expected values, forgetting
that, in some scenarios (if NPV < 0), rational managers will not
exercise the option to develop the petroleum field.
 Consider the following data to quantify prospect value:

Petroleum prices: P = 15.1 $/bbl ;
 Economic quality of a developed reserve: q = 20% (so one barrel of
developed reserve = 0.20 x 15.1 = 3.02 $/bbl);
 Total value of the developed reserve V = q.P.B = 3.02 x B (where B is the
number of barrels of reserve);
 Development cost (D): dividing in fixed (271 MM$) plus variable term
(1.1 $/bbl of reserve), hence D = 271 + (1.1 x B)
 Using the expected value of reserve volume (B = 150 MM bbl),
the value of the prospect by the traditional method is:
Net Present Value (NPV) given a discovery: NPV = V - D = q.P.B - D 
NPV = (3.02 x 150) - (271 + 1.1 x 150)  NPV = 17 MM US$
 But the chances to discovery petroleum is only of 20% and is necessary
to drill the wildcat with cost of E = 20 MM$. So:
 Expected Monetary Value: EMV = - 20 + (20% x 17) 
EMV = - 16.6 MM US$ (and the prospect is a worthless asset)

Prospect with Option to Develop
 Considering that rational managers will not exercise the
option to develop the petroleum field if it is unprofitable,
the prospect value changes a lot. See the table below.
 Considering the option, the expected monetary value
(EMV) is: EMV = - 20 + (20% x 100)  EMV = 0
 Hence, now we are indifferent to drill the wildcat well.
Prospect Valuation and Revelation
 The previous option analysis consider only uncertainty
in the reserve size and the option to develop as a “nowor-never” option (option expiring)



However is not a “now-or-never” option, it is a 5 years option;
In 5 years we shall have many different scenarios due both
uncertainties, market (oil prices, costs) and technical (geology)
Revelation of Geology: with the time, the exploratory activity
of the whole industry in the basin will reveal good or bad news
about the success probability, the productivity of reserve (so,
the economic quality of a reserve q), the size of reserves, etc.
 In
5 years several wildcats shall be drilled in the same basin, revealing
new values for success chances, reserve productivity and volume, etc.
 You can wait and see the revelation of information (free information)

If you have an option (not an obligation), in 5 years the option
will be exercised only if the scenarios combination is favorable.
Prospect Valuation under Uncertainty
 The table below present the probability distributions at t = 5 years
for some uncertain geologic parameters (revelation scenarios)
and for one uncertain market parameter (oil prices).
Parameter
Distribution
Values
Success Probability for
the wildcat well
Economic Quality for
the Developed Reserve
Minimum = 10%
Most Likely = 20%
Maximum = 30%
Multiplicative Factor
for the Reserve Size
Distribution
Minimum = 0.5
Most Likely = 1
Maximum = 1.5
Mean = 15.1 US$/bbl
Oil Prices
Standard-Deviation = 6
US$/bbl
Exploratory Prospect Uncertainty
 Considering the uncertainties in oil prices, economic
quality of reserve, success probability; and reserve size.


Considering probabilistic distributions but keeping the same
expected values (assumptions at t = 5 y. not more optimistic)
Without considering the options, the expected monetary value
(EMV) @ t = 5 years is negative as before (- 16.6 MMUS$)
Exploratory Prospect and Revelation
 However, @ t = 5 years you will exercise the option only
if the NPV is positive. So, the unfavorable scenarios will
be pruned (if NPV < 0, set value = zero)

Options asymmetry leverage prospect valuation. EMV = + 14.8
Real Options Asymmetry and Valuation
+
=
Prospect Valuation
Traditional Value = - 16.6
Options Value = + 14.8
Prospect Valuation under Uncertainty
However, the value with revelation occurs in the
future, @ t = 5 years. Discounting this EMV
using a discount rate = 10% p.a., we get:
 Present Value
of EMV = PV(EMV) = 9.19 MM$
 There is a rent tax to retain the area of concession,
but this value is small for exploratory blocks:

Rental = US$ 3,000/year; PV(Rental) = 0.01 MM$
Hence, the prospect value with revelation is:
 Value = 9.18 MM$ > > traditional value ( -16.6 MM$)
 In reality, the correct value is even higher, because is
possible that the option becomes “deep-in-themoney” before 5 years

Depending on both market evolution and partial revelation
of geology, the option can be exercised before t = 5 years
Prospect Valuation under Uncertainty
 Considering the option feature of real assets, we get a very
different result when comparing with the traditional value.
 Now is easy to see that higher uncertainty means
higher value if you have time and flexibility (options)
 Higher geologic uncertainty: non-mature basins

Higher “revelation” potential than mature basins
 But in the valuation we consider
European option (exercise only
@ t = 5 years). This is a lower
bound for the true option value.
 Considering an American option
(option can be exercise earlier),
this value is even higher:

Correct PV(EMV) > + 9.18 MM $
E&P Process and Options
Oil/Gas Success
Probability = p
 Drill the wildcat (pioneer)? Wait? Extend?
Expected Volume
of Reserves = B
 Revelation: additional waiting incentives
Revised
Volume = B’
 Appraisal phase: delineation of reserves
 Technical uncertainty: sequential options
 Delineated but Undeveloped Reserves.
 Develop? “Wait and See” for better
conditions? Extend the option?
 Developed Reserves.
 Expand the production?
Stop Temporally? Abandon?
Sequential Options (Dias, 1997)
“Compact Decision-Tree”
Note: in million US$
( Developed Reserves Value )
( Appraisal Investment: 3 wells )
( Development Investment )
( Wildcat
Investment )
EMV = - 15 + [20% x (400 - 50 - 300)]
 EMV = - 5 MM$
 Traditional
method, looking only expected values,
undervaluate the prospect (EMV = - 5 MM US$):


There are sequential options, not sequential obligations;
There are uncertainties, not a single scenario.
Sequential Options and Uncertainty
 Suppose that each
appraisal well reveal
2 scenarios (good and
bad news)
 development option will not
be exercised by rational
managers
 option to continue the
appraisal phase will not
be exercised by rational
managers
Option to Abandon the Project
 Assume
it is a “now
or never” option
 If we get continuous
bad news, is better
to stop investment
 Sequential options
turns the EMV to a
positive value
 The EMV gain is
3.25 - (- 5) = $ 8.25
being:
$ 2.25 stopping development
$6
stopping appraisal
$ 8.25 total EMV gain
(Values in millions)
Oil/Gas Success
Probability = p
Expected Volume
of Reserves = B
Revised
Volume = B’
E&P Process and Options
 Drill the pioneer? Wait? Extend?
 Revelation, option-game: waiting incentives
 Appraisal phase: delineation of reserves
 Technical uncertainty: sequential options
 Delineated but Undeveloped Reserves
 Develop? “Wait and See” for better
conditions? Extend the option?
 Developed Reserves.
 Expand the production?
Stop Temporally? Abandon?
The Extendible Maturity Feature
Period
Available Options
t = 0 to T1:
[Develop Now] or [Wait and See]
T I M E
First Period
T1: First
Expiration
T1 to T2:
Second Period
T2: Second
Expiration
[Develop Now] or [Extend (pay K)]
or [Give-up (Return to Government)]
[Develop Now] or [Wait and See]
[Develop Now] or
[Give-up (Return to Government)]
Extendible Options: Dias & Rocha (1998/9)
 Options
with extendible maturities was studied by
Longstaff (1990) for financial applications
 We (Dias & Rocha, 1998/9) apply the extendible
options framework for petroleum concessions.
 The
extendible feature occurs in Brazil, Europe, USA
 Base case of 5 years plus 3 years by paying a fee K
(taxes and/or additional exploratory work).
 Included into model: benefit recovered from the fee K
Part
of the extension fee can be used as benefit (reducing
the development investment for the second period, D2)
 We consider both stochastic processes for oil prices,
the traditional geometric Brownian motion and the
more realistic mean-reversion process with jumps
Extendible Option Payoff at the First Expiration
 At
the first expiration (T1), the firm can develop the
field, or extend the option, or give-up/back to govern
 For geometric Brownian motion, the payoff at T1 is:
Nominal Prices for Brent and Similar Oils (1970-1999)
 We see oil prices jumps in both directions, depending of
the kind of abnormal news: jumps-up in 1973/4, 1978/9,
1990, 1999; and jumps-down in 1986, 1991, 1997
Jumps-up
Jumps-down
Poisson-Gaussian Stochastic Process
 We
adapt the Merton (1976) jump-diffusion idea
for the oil prices case, considering:
 Normal
news cause only marginal adjustment in oil
prices, modeled with a continuous-time process
 Abnormal rare news (war, OPEC surprises,...) cause
abnormal adjustment (jumps) in petroleum prices,
modeled with a discrete time Poisson process
 Differences
between our model and Merton model:
 Continuous
time process: mean-reversion instead the
geometric Brownian motion (more logic for oil prices)
 Uncertainty on the jumps size: two truncated normal
distributions instead the lognormal distribution
 Extendible American option instead European vanilla
 Jumps can be systematic instead non-systematic
C++ Software Interface: The Main Window
 Software solves extendible options for 3 different stochastic processes
and two methods (dynamic programming and contingent claims)
The Options and Payoffs for Both Periods
Period
t = 0 to T1:
T I M E
First Period
T1: First
Expiration
T1 to T2:
Second Period
T2: Second
Expiration
Options Charts
Real Applications of this Model
 A similar stochastic process of mean-reversion with
jumps was used to equity design (US$ 200 millions) for
the Project Finance of Marlim field (deepwaters, Brazil)
 The extendible options has been used to analyze the
development timing of some projects in Campos Basin
 The timing policy was object of a public debate in
Brazil, with oil companies wanting a higher timing and
this model gave some contribution to this debate:

We defended a longer timing policy compared with the first
version of the ANP (Brazilian national petroleum agency)
 In April/99, the notable economist and ex-Minister Delfim
Netto defended a timing policy for petroleum sector citing
our paper conclusions about timing policies to support his
view! (Folha de São Paulo, a top Brazilian newspaper)
Oil/Gas Success
Probability = p
Expected Volume
of Reserves = B
Revised
Volume = B’
E&P Process and Options
 Drill the pioneer? Wait? Extend?
 Revelation, option-game: waiting incentives
 Appraisal phase: delineation of reserves
 Technical uncertainty: sequential options
 Delineated but Undeveloped Reserves.
 Develop? “Wait and See” for better
conditions? Extend the option?
 Developed Reserves.
 Expand the production?
Stop Temporally? Abandon?
Option to Expand the Production
 Analyzing a large ultra-deepwater project in
Campos Basin, we faced two problems:

Remaining technical uncertainty of reservoirs is still
important. In this specific case, the better way to solve the
uncertainty is by looking the production profile instead
drilling additional appraisal wells
 In the preliminary development plan, some wells
presented both reservoir risk and small NPV.
Some
wells with small positive NPV (not “deep-in-themoney”) and others even with negative NPV
Depending of the initial production information, some wells
can be not necessary
 Solution: leave these wells as optional wells
 Small investment to permit a future integration of these
wells, depending of the market evolution and the
production profile response
Modelling the Option to Expand
 Define the quantity of wells “deep-in-the-money” to
start the basic investment in development
 Define the maximum number of optional wells
 Define the timing (or the accumulated production) that
the reservoir information will be revealed
 Define the scenarios (or distributions) of marginal
production of each optional well as function of time.


Consider the depletion if we wait after learn about reservoir
Simplify considering yearly distributions and limiting the
expiration of the option (declining NPV due the depletion)
 Add market uncertainty (reversion + jumps for oil prices)
 Combine uncertainties using Monte Carlo simulation
 Use optimization method to consider the earlier exercise
of the option to drill the wells, and calculate option value

Monte Carlo for American options is a frontier research area
Conclusions
 Real
Options is the new paradigm for economic analysis
of assets, projects, and opportunities under uncertainty.


Real options can be viewed as a NPV maximization given the
options and given the uncertainties/stochastic processes
Need training, knowledge, and good computers
 Valuation
of rights/projects using traditional methods
underestimates values, resulting on very wrong values.


Implications for petroleum real assets negotiations, bids, etc.
Implications for investment decisions and portfolio selection
 Firms




need to develop simple and more complex models.
Simple models are important for fast calculations.
Interactive interface, charts, and educational work.
Real world and specific issues demand also more complex and
“taylor-made” models: in-house models
Firms need to follow the state of the art and the growing literature