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34

I

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

I

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

topics relevant to our readership. Core areas

include market and credit risk measurement &

management, the pricing and hedging of deriva-

tives and/or structured securities, and the theo-

retical modelling and empirical observation of

markets and portfolios with particular emphasis

on the energy industry. This list is not exhaustive.

The most important publication criteria are

originality, exclusivity and relevance – we

attempt to strike a balance between them. Given

that EPRM technical articles are shorter than

those in dedicated academic journals, clarity of

exposition is another yardstick for publication.

Once received by the editor, submissions are

logged and checked against the criteria above.

Articles that obviously fail to meet one or more

are rejected at this stage.

Articles then are sent to one or more anony-

mous referees for peer review. Our referees are

drawn from the research groups, risk manage-

ment departments and trading desks of major

financial and energy institutions, as well as from

academia. Many have already published in EPRM.

Depending on the feedback from referees, the

editor makes a decision to reject or accept the

submitted article. His decision is final. Submissions

should be sent, preferably by e-mail, to the editor,

James Ockenden (jockenden@riskwaters.com).

The preferred format is Microsoft Word,

although Adobe PDFs are acceptable, and ideally

any equations should be in Mathstype format.

The maximum recommended length for articles is

3,500 words, with some allowance for charts

and/or formulae – that is, this wordcount should

be reduced proportionately, depending on the

number of charts/tables/formulas included.

We expect all articles to contain references to

previous literature. We reserve the right to cut

accepted articles to satisfy production consider-

ations. Authors should allow four to eight

weeks for the refereeing process.

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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