Andika Rivai

in Partial Fulfillment of the Requirements for the Dual Degree of

MBA / MSc in Financial Management


Summary of the proposal

Insight and techniques derived from option pricing
enable the quantification of elements of
managerial flexibility and strategic interactions, which have thus far been ignored or
underestimated by standard net present value or discounted cash flow methods.

Management’s flexibility to revise its future actions in response to future market circumstances
expands an investment opportunity’s value by improving its upside potential and limiting
downside losses relative to initial expectations under passive management. The resulting
asymmetry caused by managerial adaptability calls for an expanded NPV rule that reflect both
value components: the traditional (static or passive) NPV of direct cash flows and the option
value of this flexibility.
(Maeseneire, 2006)

Expanded (strategic) NPV =
Passive NPV of expected cash flows + Value of options from active

Oil and Gas Industry is ideally suited for a real options-type analysis because the companies
exhibit all the necessary ingredients:
 Large capital investments.
 Exclusivity (once lease of oil/ gas assets secured)
 Uncertain revenue streams (sensitive to oil price).
 Often long lead times to achieve these uncertain cash flows.
 Reserves uncertainty (reservoir size and quality).
 Numerous technical alternatives at all stages of development.
 Political risk and market exposure.
(Bailey, 2006)

The objective of the thesis is to (1) argue that traditional approaches to valuation are
inadequate, (2) highlights the importance of real options analysis as valuation and decision
making tool in upstream projects using a real
case study, (3) warns that setting out possible
future choices usually calls for a strong dose of judgment.

Key words: Real Options, Decision Trees, Monte Carlo Simulations, Discounted Cash Flow
(DCF), Net Present Value (NPV), Risk, Uncertainty, Upstream Project, Exploration and
Production, Oil Field Development.

From 1970s onward, the financial world began developing contracts called puts and calls which give their
owner the right but not the obligation to sell or buy a specified number of shares or a quantity of a commodity
such as gold or oil, at or before a specified date. (A. Galli, 1999)

In order not to reveal any restricted information, the project data will be modified and the project described
here may not be assumed to be any particular field development

Background to the problem to be investigated (theory)

A growing number of managers and academics are becoming convinced that the traditional
approaches to valuation are inadequate since they do not properly capture managerial flexibility
to adapt and revise later decisions in response to unexpected market development.

This real options approach has the potential to conceptualize and quantify the value of options
from active management. This value is manifest as a collection of real (call or put) options
embedded in capital investment opportunities, having as an underlying asset the gross project
value of expected operating cash flows.

The value of flexibility and thus the real option value of a project are at their greatest when
there is considerable uncertainty about the future and much room for managerial flexibility. Real
option is especially relevant for ‘grey zone projects’ (NPV near zero) as including value of
management’s options may affect the ultimate decision to invest.

Since the mid-1990s Real Options began to attract attention from industry as an important tool
for both valuation and strategy. Beginning principally in the Oil and Gas industry, and extending
to a range of other industries, consultants and internal analyst started to apply this concept to
major corporate investments.
(Maeseneire, 2006)

Real Options in Oil and Gas Industry

As E&P companies search to replenish ever-decreasing hydrocarbon supplies, they now find
themselves looking in some of the most inaccessible parts of the globe and in some of the
deepest and most inhospitable seas. What could have been achieved in the past with a
relatively small investment is now only attainable at a considerably greater cost. In other words,
developing an oil/ gas field nowadays is subject to considerably larger investments in time,
money, and technology.

Furthermore, such large investments are almost always based on imperfect, scant, and
uncertain information. It is no accident, therefore, that when teaching the concept of risk
analysis, many authors cite the oil industry as a classic case in point. This is not by accident for
few other industries exhibit such a range of uncertainty and possible downside exposure (in
technical, financial, environmental, and human terms). Indeed this industry is almost ubiquitous
when demonstrating risk analysis concept.

Consequently real options have a natural place in the oil industry management decision-making
process. The process and discipline in such an analysis captures the presence of uncertainty,
limited information, and the existence of different development scenarios.
(Bailey, 2006)

Analogy between Financial Options and Real Options

Black-Scholes-Merton’s Financial Options Paddock, Siegel, and Smith’s Real Options

Financial option value Real option value of an undeveloped reserve.

Current stock price Current value of developed reserve.

Exercise price of the option Investment cost to develop the reserve.

Stock dividend yield. Cash flow net of depletion as proportion of
current value of developed reserve.

Risk-free interest rate. Risk-free interest rate.

Stock volatility. Volatility of developed reserve.

Time to expiration of the option. Time to expiration of the investment right.

(Dias, 2004)

The exploration and production can be viewed as part of multistage investment problem
and a sequential real options process.

Option to Explore

During the exploration phase Managers face the wildcat drilling
decision, which is optional in most cases.

Option to Appraise

In case of success (oil/ gas discovery), the firm has the option to
invest in the appraisal phase through delineation wells and
additional 3D seismic, in order to get information about the volume
and quality of the reserves.

Option to Develop, to
Relinquish, and to Wait

When the remaining technical uncertainty does not justify additional
investment in information, the firm has the option to develop the
reserve by committing a large investment in the development phase.
The firm can also relinquish the undeveloped reserve to the
governmental agency or wait for better conditions (until a certain

Option to Expand, to
Stop Temporarily
, and
to Abandon

Finally, the firm has operational options during the reserve producing
life, such as the option to expand the production, the option of
temporary suspension of the production, and even the option to
abandon the concession.

(Dias, 2004)

It is possible to ignore both temporary stopping and abandonment options in the presence of the option to
delay the investment for initial oilfield development purposes. (Saul B. Suslick, 2009)

Data required and methodology proposed

Data simplification

In real-world upstream petroleum economic models, field assumptions are the combined
product of the efforts of earth scientists and petroleum engineers. Each of their disciplines is
beyond the scope of this thesis, which focuses on how real options can be applied to valuation
and decision making. Therefore, we will use raw technical data, with no attempt to make them
any more detailed than needed to make our valuation and decision making points.

Data requirement

A case study of upstream projects that can illustrates where real options analysis can be used
to add value in valuation and decision making process, with data required such as:

 Sample oil fields
 Initial development choices
 Key uncertainties
 Inflation rate
 Discount rate
 License length
 Price forecast
 Production volumes
 Capital expenditure before production starts
 Capital expenditure after production starts
 Fixed operating expenses
 Variable operating expenses
 Abandonment cost

Or alternatively, an access to Wood-Mackenzie Upstream database of oil and gas field
development economics - Global Economic Model

Once a sample oil field project identified, the following activities can be expected:

 Data study and discussion to understand general features and current valuation method
 Data study and discussion to identify and model uncertainties
 Data study and discussion to identify options available to the project

Data confidentiality

In order not to reveal any restricted information, the project data will be modified and the project
described will not be attributed to any particular field development. To ensure data
confidentiality, the Company, Student, and Rotterdam School of Management can enter into
agreement of confidentiality.

Methodology proposed

General framework for valuing real options

Step 1 A first step is to compute the base case PV of the project without flexibility.
Output of this step is traditional PV without flexibility

Step 2

A second step is to model uncertainty; an event tree shows how the value of the
underlying may evolve in the future. Still no flexibility, in this step estimating
uncertainty is critical.

Step 3

A third step involves the identification of all the options inherent to the project and to
decide when management will exercise which option. In this step flexibility is
incorporated into event trees, which transforms them into decision trees.

Step 4

In the final step the value of the project with flexibility is computed and the real option
value is determined. ROA includes the base case present value without flexibility plus
the option value.

(Maeseneire, 2006)

General framework for valuing portfolio of projects and real options

Step 1 Start by making a list of all investment opportunities.

Step 2 Carry out a base case (without flexibility) analysis for each project.

Step 3 A traditional static DCF is obtained for each project.

Step 4 The sources of uncertainty in each project are identified: volatility and correlations are
determined (potentially with the help of Monte Carlo analysis).

Step 5 Frame the real options for each project.

Step 6 Calculate the real option value of each project, via simulation, binomial lattices or
closed form solutions.

Step 7 A company’s portfolio of projects and overall resource allocation can be optimized by
taking project interdependencies and budget constraints into account.

Step 8 Create reporting materials and do follow-up of the project: at each decision point, the
information available at that time should be considered in potentially revising the

(Mun, 2006)

Proposed schedule to complete the project

 Thesis and Internship Registration Form. 21 October 2013.
 Thesis and Internship Project Proposal. 25 November 2013.
 First Meeting with Thesis Supervisor
9 December 2013.
 Second Meeting with Thesis Supervisor 23 December 2013
 Third Meeting with Thesis Supervisor. Draft Thesis Report. 17 January 2014.
 Final Thesis Report. 14 February 2014.

A short reference of relevant literature

A. Galli, M. A. (1999). Comparing three methods for evaluating oil projects: option pricing, decision
trees, and monte carlo simulations. Hydrocarbon Economics and Evaluation Symposium.
Dallas: Society of Petroleum Engineers.
Bailey, W. (2006). Schlumberger on Real Options in Oil and Gas. In J. Mun, Real Option Analysis:
Tools and techniques for valuing strategic investments and decisions (pp. 44-48). New
Jersey: John Wiley & Sons, Inc.
Dias, M. A. (2004). Valuation of exploration and production assets: an overview of real options
models. Journal of Petroleum Science and Engineering, 93-114.
Hans T. J. Smit, L. T. (2006). Strategic Planning: Valuing and Managing Portfolios of Real Options.
R&D Management, 403-419.
Maeseneire, W. D. (2006). The Real Options Approach to Strategic Capital Budgeting and
Company Valuation. Brussel: The Boeck & Larcier NV.
Mun, J. (2006). Real Options Analysis versus Traditional DCF Valuation in Layman's Terms.
Dublin: Real Options Valuation, Inc.
Saul B. Suslick, D. S. (2009). Uncertainity and Risk Analysis in Petroleum Exploration and
Production. Terrae, 30-41.

An abridged version of student’s CV

Andika Rivai had 10+ years of experience as Consultant and
Finance Manager in PricewaterhouseCoopers and Baker Hughes
Inc. -Oilfield Services. During his career, he demonstrated financial
management skills and ability to collaborate effectively with peers,
senior managers, and internal clients. He has been posted in
multiple locations across Middle East and Asia Pacific in cities such
as Perth, Dubai, Beijing, Shekou, Duri, and Jakarta. He currently
pursues MBA/MFM Dual Degree in Rotterdam School of
Management, Erasmus University.

Thesis Supervisor is Drs. Hans Haanappel