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Valuation of Undeveloped Oil Reserves with Option Pricing Model (OGEL 2006)

Valuation of Undeveloped Oil Reserves with Option Pricing Model (OGEL 2006)

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Published by blubiantara
Option pricing upstream petroleum
Option pricing upstream petroleum

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Published by: blubiantara on Aug 25, 2010
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(Oil, Gas & Energy Law Intelligence): Focusing on recentdevelopments in the area of oil-gas-energy law, regulation,treaties, judicial and arbitral cases, voluntary guidelines, taxand contracting, including the oil-gas-energy geopolitics.For full Terms & Conditions and subscription rates, please visitour website atwww.gasandoil.com/ogel/.
Open to all to read and to contribute
Our aim is for OGEL to become the hub of a globalprofessional and academic network. Therefore we invite allthose with an interest in oil-gas-energy law and regulation tocontribute. We are looking mainly for short comments onrecent developments of broad interest. We would like wherepossible for such comments to be backed-up by provision ofin-depth notes and articles (which we will be published in our 'knowledge bank') and primary legal and regulatorymaterials.Please contact
Thomas Wälde attwwalde@aol.comif you would like to participate in thisglobal network: we are ready to publish relevant and qualitycontributions with name, photo, and brief biographicaldescription - but we will also accept anonymous ones wherethere is a good reason. We do not expect contributors toproduce long academic articles (though we publish a selectnumber of academic studies either as an advance version or an OGEL-focused republication), but rather concisecomments from the author's professional ’workshop’.OGEL is linked to
, the electronic energy law, policyand economics information and discussion forum moderatedby Thomas Wälde.
Thomas W. Wäldetwwalde@aol.comProfessor & Jean-Monnet ChairCEPMLP/Dundee© Copyright OGEL 2006
OGEL Cover v1.3
Oil, Gas & Energy Law Intelligence
Valuation of Undeveloped Oil Reserveswith Option Pricing Modelby B. Lubiantara
Issue : Vol. 4 - issue 4November 2006
Valuation of Undeveloped Oil ReservesWith Option Pricing Model
Benny Lubiantara
Executive SummaryModern financial theories such as option theory are increasingly being used toevaluate 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 NPVand IRR. These methods assume that the project is of a “now or never” nature. Infact, this is not the case; as an investor, one has many choices, such as to defer theproject if it is not seen as being economically viable. One can also choose to expandor increase production capacity if the price of the commodity rises. The DCF methodoften condemns a project as being “uneconomical” simply because it does not takeinto consideration such flexibility. Logically, the existence of such options or flexibilityshould add to the project’s value.This paper will discuss how the option approach that is usually used in modernfinancial management theory can be applied to the evaluation of undevelopedreserves. Option is a right, not an obligation. Options have similarities to projectsinvolving mineral reserves. As an Investor, one has the right to develop thereserves; on the other hand, if economic conditions are not conducive, one has theoption to postpone the project. This paper will explain how to evaluate the economicviability of an oil reserve that has not been developed (an undeveloped reserve) onthe 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.
Decision making in Corporate Investment has always been a difficult undertaking foranalysts. Traditionally, NPV and Decision Trees have been the fundamental tools formodeling investment opportunities. Recently, there has been a growing interest infinancial Option Pricing Models (OPM) in the corporate investment domain. The valueof flexibility under uncertainties has been realized long back. Decision trees were theonly available tools to quantify this value. However, the complexity of decision treeshas hindered their widespread adoption. Real options offer a simpler alternative toassess the value of this flexibility.Options have been studied extensively in financial literature and are well understoodin financial domain. An option confers upon the owner the right, but not theobligation, to take an action in the future. Options always have timing restrictions.Every option has an
expiration date
after which the option can no longer beexercised.
European Options
can only be exercised on their expiration date unlike
 American Options
that can be exercised on or before their expiration. Americanoptions offer interesting opportunities to the owner. The value of the option changes
over time, as future uncertainties are resolved. The owner can maximize his/herprofits by exercising it at the right moment. Options also differ in terms of the rightbeing conferred. In financial market terms, a
call option
confers upon the owner theright to purchase a security at a fixed price where as a
 put option
offers the right tosell a security at a fixed price.There are six factors affecting the price of the option,
Current stock prices
Strike price
The time to expiration
The volatility of the stock prices
The risk free interest rate
The dividends expected during the life of the optionThere are two most popular methods to calculate the value of the option: first, BlackScholes (BS) method, this method basically using the straightforward formula.Scholes, Merton and Black developed an analytical solution and received the NoblePrize in economics in 1997. The second method is Binomial Tree approach. Thispaper will discuss only the second method, the first method is beyond the scope of this paper, for those who interest should refer to our previous paper (reference 5).
The Binomial Option Pricing Formula
The Binomial tree assumes that the stock price follows a multiplicative binomialprocess over discrete periods. The rate of return on the stock over each period canhave two possible values:
u –
1 with probability q, or
1 with probability 1
.If the current stock price is
, the stock price at the end of the period will be either
with probability
with probability 1
– q
 To see how to value a call on this stock, start with the simplest situation: theexpiration date is one period. Let C the current value of the call,
is its value atthe end of the period if the stock price goes to
is its value at the end of the period if the stock price goes to
. Since there is now only one period remainingin the life of the call, a rational exercise policy imply that
= max[0,
uS – K 
] and
= max[0,
dS – K 
]. Therefore,
= max[0,
uS – K 
] with probability
= max[0,
dS – K 
] with probability 1
– q
 Suppose we form a portfolio containing
shares of stock and the dollar amount
inrisk less bonds. This will cost
. At the end of the period, the value of thisportfolio will be:

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