Cutting edge: Exploration & production

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August 2003
I
n this article, we aim to describe an efficient option method for
the valuation of an exploration and production project. Consider
the example of a project manager who has the right to start drilling
on a given oil reserve in any one of five designated years, called
‘decision’ years. Two years after the drilling starts, crude oil and natural
gas will be produced for 12 consecutive ‘return’ years, all of which, it is
assumed, the company will sell on the spot market.
This right resembles an American-style option (Bermudan), and if we
are prepared to make the assumptions required for the application of
derivative techniques, we may value it accordingly. However, using tradi-
tional approaches and somewhat realistic oil and gas price models, such
an option can be cumbersome to calculate. For example, the construc-
tion of the binomial tree and the calculation along it can be tedious and
time-consuming. We aim to show that a recently proposed least-squares
Monte Carlo approach (Longstaff and Schwartz (2001)) can solve this
problem very efficiently. It is easier to implement and allows more
general stochastic processes for state variables (oil and gas prices) than
with traditional approaches.
Valuing investment projects of this sort represents a classic example
of real option valuation. The main purpose of this article is to introduce
a new calculation technique for a familiar industry problem. Hence we
will not consider in detail some common – but important – issues asso-
ciated with real option valuation.
That said, we still want to bring attention to these issues and to the
limitations of our approach. One problem area concerns the discounting
of future cashflows. For investment commodities such as gold, we can
evaluate futures output at current spot prices without discounting. For
consumption commodities such as oil and gas, future output is not quite
the same as current output. Hence, we need to consider the convenience
yield and cost-of-carry – respectively the benefit and cost of carrying the
commodity – to determine the proper discount rate.
In actual calculation, instead of changing the discount rate, we continue
to use the risk-free interest rate and instead adjust down the drift term of
the spot price process by the convenience yield. If the commodity has a
futures market, we can use its futures prices to determine the average
convenience yield and, therefore, the proper drift (Brennan and Schwartz
(1985)). However, when the commodity does not have a futures market or
one that extends long enough – more than 18 years in our example – then
we have to determine the drift differently. In this case, the price process
needs to have a ‘risk-adjusted drift’ – that is, the original drift minus a risk
premium determined from an equilibrium model. Similarly, if output has
an unhedgeable risk – for example, volume uncertainty – we must deduct
another risk premium from the drift (Cox, Ingersoll and Ross (1985);
Schwartz and Trigeorgis, chapter 1, (2001)).
The deduction of risk premiums is an acknowledgement that under
these conditions, the full value of starting an investment project on a flex-
ible date instead of a pre-determined date, is not hedgeable. Therefore the
certainty-equivalent value of it is lower.
In the rest of the article we explain the basics of the least-squares
approach and report results of its application for our example.
The least-squares approach to calculating
an American-style (Bermudan) option
In each decision year, the project manager would compare the expected
value from oil and gas production if drilling were to start immediately
(the exercise value) with the expected value if drilling were to start later
(the continuation value). He starts drilling if the exercise value is larger.
For a given time and price path, the manager calculates the exercise value
from the net present value of cashflows, and the project value is the
discounted exercise value averaged over many simulated price paths.
The innovative part of the least-squares approach is in the calculation
of continuation value. We may estimate the continuation value by project-
ing cashflows realised from continuation on to the space spanned by
current prices – we can do this through a simple regression. Detailed steps
for this process are explained in a simple numerical example in Longstaff
and Schwartz (2001, pages 115–120). We provide a simple schematic
description in the equation below. But to fully understand the process,
one should work through their example, which can be easily reproduced
using a spreadsheet or by hand.
As shown above, we assume there are n price-paths. On path 1, the
current period price is s
1,t
, and the continuation value (expected project
value) next period is v
1,t +1
. Suppose next period, t +1, is the final period
to exercise, so one has to exercise. The continuation value, v
1,t +1
, is simply
the exercise value (discounted cashflow), given s
1,t +1
. Regressing
{v
1,t +1
,...,v
n,t +1
} on {s
1,t
,..., s
n,t
} yields f (s) =E(v| s), a conditional expecta-
tion function approximating the continuation value given price s.
1
Using
this function, we can compare the continuation value v
1,t
= f (s
1,t
) with the
exercise value at s
1,t
to decide whether to exercise on path 1 at time t.
For the next step, knowing {v
1,t
,...,v
n, t
} allows us to repeat the above
procedure at t –1 and so on, back to time zero. So at the end we will
know the exercise decision and value at each point in time along all price
paths. By discounting the values at the risk-free interest rate and aver-
aging them over all paths, we will obtain the expected project value at
time zero.
Hence, the key point here is that to apply this approach to evaluate
an exploration & production project, one only needs to define first the
price-generating process and second the exercise value along a price
path. We go on to define these two components and present the results
from a case study.
1, 1, 1
2, 2, 1
, , 1
Current period Next period
price project value
t t
t t
n t n t
s v
s v
s v
+
+
+

Lukens Energy Group’s Hugh Li sets out an option method for valuing exploration
and production projects, using a practical example
Valuing exploration and
production projects
1
The function f(s) is assumed to be a linear combination of some basis functions such as s
2
,
exp(–s/2) and so on. Our program used simple polynomial functions of s as bases. Calibrating over
from known American option values such as vanilla calls and puts, these basis functions perform as
well or better than other more elaborate choices proposed in Longstaff and Schwartz (2000)
http://www.risk.net/data/eprm/pdf/august2003/technical.pdf
Cutting edge: Exploration & production
36
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August 2003
The price generating process and exercise value
In a given return year t, some volumes of crude oil and natural gas are
produced. Denote respectively the volumes as v
c
(t) and v
g
(t), and the spot
market prices as s
c
(t) and s
g
(t). We assume the two prices to be mean-
reverting and correlated, as in
,
(1)
.
Note that here both the means and volatilities may be time-varying. With
these prices, we can generate revenue s
c
(t)v
c
(t) +s
g
(t)v
g
(t), which is what
we actually need. Note that this simple price process implies a certain
term structure of volatility. If we derive implied volatilities based on an
option formula assuming a different price process – notably Black-
Scholes – the volatilities will be different. Nevertheless, a big advantage
of the least-squares approach is that is does not require a specific price
process, so we are free to choose others.
Suppose the drilling starts in year t
*
. After taking into account the
royalty rate (denoted by a); field operation cost for crude, b; tax rate, d;
and discounting, ρ, the project net present value (NPV) of a given sample
path in price space is
.
The exercise value is the expected NPV. Ignoring volumetric uncertainty,
the exercise value is
.
(2)
Given (1), from Schwartz (1997),
,
where
,
and
.
*
*
2 2
2 ( ) 11 12
( ( )) (1 )
2
c
t t
t c
c
Var x t e
− α −
σ + σ
= −
α
* *
*
2 2
( ) ( ) 11 12
*
( ( )) ln ( ) ( )(1 )
2
c c
t t t t
t c c c
c
E x t s t e e
− − − −
+
= + − −
α α
σ σ
µ
α
* *
*
( ( )) ( ( )) / 2
( ( ))
t c t c
E x t Var x t
t c
E s t e
+
=
*
* * *
*
13
*
2
( 1)
( ) (( ( ( )) ( ) ( ( )) ( )) (1 )
( ) )(1 )
t
t t c c t g g
t t
t
c
E v t E s t v t E s t v t a
v t b d e
+
= +
− −
= + ⋅ − −
⋅ −

ρ
*
*
13
( 1)
*
2
( ) (( ( ) ( ) ( ) ( )) (1 ) ( ) )(1 )
t
t
c c g g c
t t
v t s t v t s t v t a v t b d e
+
−ρ −
= +
= + ⋅ − − ⋅ −

2
2
1
( ) / ( ) ( ( ) ln ( )) ( ) ( )
g g g g g j j
j
ds t s t t s t dt t dW t
=
= α µ − + σ

2
1
1
( ) / ( ) ( ( ) ln ( )) ( ) ( )
c c c c c j j
j
ds t s t t s t dt t dW t
=
= α µ − + σ

The expression for E
t
*
(s
g
(t)) is symmetric. Therefore equation 2, gives us
E
t
*
v(t
*
). Given the price-generating process (equation 1) and the exercise
value (equation 2), we can apply the least-squares approach to calculate
an expected value.
We can generalise the price process. So far, we have assumed µ
c
(t) =µ
c
,
µ
g
(t) =µ
g
, and σ
ij
(t) =σ
ij
do not vary with time. When they do vary with
time, we need to extend the results in Schwartz (1997). The derivation is
similar, but the specifics more complex. The results are listed below.
An extension: exercise value with varying price and volatility
In equation 1, let us suppose µ(t) and σ
ij
(t) are step functions µ(t) =u
k
,
σ
ij
(t) =σ
ij k
, t∈[t
k–1
, t
k
), k =1,...,T; i =1,2; t
0
=0, t
T
=T. E
t
*
(x(t)) and Var
t
*
(x(t))
in equation 2 have the following different expressions. Because the
expressions for crude oil and gas are symmetrical, for exposition purposes
we suppress the subscripts c and g.
Suppose t
*
∈[t
I1 -1
, t
I1
) for a certain I
1
, then for t ∈[t
*
, t
I1
)
,
.
For t ∈[t
I2-1
, t
I2
) with I
2
– 1≥ I
1
,
1 , 1 ,
1 2
* * 1 * 1
*
1
1 ,
2
1 * * 2 *
2 2
2 2
1
2 ( ) 1 1 2 ( ) 2 ( )
1
2
2
2 ( ) 1 2 ( ) 2 ( )
( ( )) ( ( 1) ( ( ))
2 2
( )) .
2
j I j i
I i i
j I
I
I
t t j j t t t t
t
i I
t t j t t t t
Var x t e e e
e e e



α − = = α − α −
= +
α − = α − − α −
σ σ
= − + −
α α
σ
+ −
α
∑ ∑


1 , 1
*
* 1
* 1
1 , 2
* 1 *
1
1 , 2
1 *
* 2 *
2
2
2
( )) 1 ( )
*
2
2
1
1 ( ) ( )
1
2
2
( ) 1 ( ) ( )
( ( )) ln( ( )) (( )( 1)
2
( )( )
2
( )( )) ,
2
j I
I
j i
i i
j I
I
t t j t t
t I
I
j t t t t
i
i I
t t j t t t t
I
E x t s t e e
e e
e e e


α − = −α −

= α − α −
= +
α − = α − −α −
σ
= + µ − −
α
σ
+ µ − − +
α
σ
µ − −
α




1 ,
1
*
*
2
2
1 2 ( )
( ( )) (1 )
2
j I
j t t
t
Var x t e
= − α −
σ
= −
α

1 ,
1
* *
* 1
2
2
1 ( ) ( )
*
( ( )) ln( ( )) ( )(1 )
2
j I
j t t t t
t I
E x t s t e e
= −α − −α −
σ
= + µ − −
α

Input parameter Value
Annual risk-free interest rate 5%
Annualised volatility of crude 60%
Annualised volatility of gas 80%
Correlation coefficient between crude and gas 30%
Royalty rate 12%
Expense $6.15/barrel
Tax rate 35%
Mean-reversion rate for crude and gas 0.036
Mean price level for crude $20.00
Mean price level for gas $3.00
Initial crude price $20.4/barrel
Initial gas price $3.2/mcf
Source: author
Table 1: Input parameters
Year Crude oil (barrels) Natural gas (mcf)
1 15,288,100 29,163,713
2 16,285,150 30,742,375
3 15,121,925 25,923,300
4 13,377,088 22,682,888
5 11,466,075 19,442,475
6 6,813,175 12,961,650
7 5,733,038 8,101,031
8 4,777,531 4,860,619
9 2,866,519 3,240,413
10 1,911,013 1,744,838
11 997,050 1,578,663
12 913,962 1,578,663
Source: author
Table 2: Annual volumes
www.eprm.com
I
37
In both expressions, when I
2
– 1=I
1
, the term should be
dropped. Again, from equation 2, we know the exercise value E
t
*
v(t
*
).
A practical example
We applied the above approach to an actual case and report the results
here. Table 1 shows the input parameters, assuming constant mean and
volatility. And for this reserve, once the production begins, table 2 gives
the annual volumes. Table 3 gives the expected discounted cashflows
when the drilling starts in each of the six decision years.
The total expected project value is $837.1 million. As expected, this
figure exceeds any of the NPVs with predetermined starting dates. The
additional value is the premium for the option of a flexible starting date
(the option value). We also ran the case with volatility at half the level
assumed above while keeping all other parameters unchanged – the total
expected project value dropped to $797.1 million. There is a not insignif-
icant $40-million-dollar fall in project value as a result of the lower
volatility.
A note on hedging
We have calculated an option value that accounts for the higher value of
being able to start drilling at an optimal time in the presence of market
volatility. If we choose to hedge, we can monetise an option value. How
do we hedge such a real option?
Once the drilling starts – that is, the option is exercised – equation two
shows that the exercise value is a function of expected spot prices in the
future, which are equal to futures prices. Ideally, if there are futures
contracts for all these years, they can be straightforwardly hedged. From
a practical point of view, the New York Mercantile Exchange has only
seen six years of crude and natural gas futures trading, with very little
2
1
1
1
(.)
I
i I

= +

EPRM welcomes technical article submissions on
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CALL FOR PAPERS
liquidity at two years and beyond. Hence, in our case, we have to use
short-term futures contracts to hedge longer-term price risks by ‘rolling
the hedge forward’.
For example, to hedge the price risk in the fourth year, we first go short
on contracts with delivery in the second year. Then, just before their expi-
ration, close them out and go short on contracts with delivery in another
two years. And then, just before these new contracts’ expiration, close them
out and sell production in the spot market.
The downside of rolling hedges forward is that as we have incurred
the basis risk – from the price change in closing out contracts – the hedge
will be imperfect. This basis risk – like the volume risk and other unhedge-
able risks – must be accommodated in the risk-adjusted drift. EPRM
Huagang ‘Hugh’ Li is director of research at Lukens Energy Group in Houston.
email: hli@lukensgroup.com
The author thanks Jeff Cliver, Hua Fang, Fred Hagemeyer, Jay Lukens,
Rafael Mendible and Scott Smith
References
Cox, JC, Ingersoll, JE and Ross, SA , An intertemporal general equilibrium
model of asset prices, Econometrica, 53, pages 363–384, 1985
Dixit, AK and Pindyck, RS, Investment under Uncertainty, Princeton Univer-
sity Press, 1994
Longstaff, FA and Schwartz, ES, Valuing American options by simulation: a
simple least-squares approach, The Review of Financial Studies, 14, 1, pages
113–147, Spring 2001
Brennan, MJ and Schwartz, ES, A new approach to evaluating natural sesource
investments, Midland Corporate Finance Journal, pages 37–47, Spring 1985
Schwartz, ES, The stochastic behaviour of commodity prices: implications for
valuation and hedging, Journal of Finance, 52, 3, pages 923–973, 1997
Schwartz, ES and Trigeorgis, L, ed., Real Options and Investment under
Uncertainty – Classical Reading and Recent Contributions, MIT Press, 2001.
Start date Project net present value ($ millions)
Immediately 781.9
Year 1 750.9
Year 2 704.1
Year 3 673.2
Year 4 638.8
Year 5 610.7
Source: author
Table 3: Expected cashflows

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