KG Basin

Rights to explore and produce oil and gas

Economically/Commercially feasible or viable - drill and develop the blocks

If the block proves to be uneconomic - you shelve the plan to devleop it as the cost benefit analysis is not in the favor
of the company

Uneconomic blocks - sell them to other companies

the buyer may buy it for geographical fit/strategic fit

Instead of doing this, taking a decision right on day1 to invest or not -

what if I have an option to dvelop this 3 years later by when
I can invest in technology for better exploration and increase the
reserves

Price of the final product in the next 3-5 years

Why is it not used frequently?

alysis is not in the favor
Investment Tenure 3.00 Years
Cost of Capital 14%
Investment $ 1,000
Expected cash flows $ 400

Investment $ (1,000)
Year 1 $ 400
Year 2 $ 400
Year 3 $ 400
NPV $ (71.35)

Best Case Scenario $ 600.00

Best Case Probability 50%
Worst Case Scenario $ 200.00
Worst Case Probability 50%
Expected cash flows $ 400.00

Abandoment option - salvage value $ 650.00 end of year 1

Case 1: Case 2:
Project is a failure Project is a success
Investment $ (1,000) Investment $ (1,000)
Year 1 $ 200 Year 1 $ 600
Year 2 $ 200 Year 2 $ 600
Year 3 $ 200 Year 3 $ 600
NPV $ (535.67) NPV t = 0 $ 392.98

Weighted Average NPV Value of the abandonment option:

With option - NPV
Successful (Best Case) 50% $ 392.98 Without option - NPV
Unsuccessful (Worst Case) 50% $ (254.39) value of the option
(with an abandonment option)
One Plus 7
Wt. avg. NPV $ 69.30 One Plus 8
Difference
is the value of the features
Case 3:
Project is a failure and you opt to close the project at the end of year 1
 Investment $ (1,000)
Year 1 $ 200 0.877193
Year 1 $ 650 0.877193

NPV t = 0 $ (254.39)

he abandonment option:
$ 69.30
ption - NPV $ (71.35)
$ 140.64

55000 without features NPV without option

60000 with features NPV with option
5000 value of features value of the option
e of the features
 Option pricing models

Black Scholes formula or BS Merton formula

Price of financial option =

Financial option lever

NPV
Considera Stock Price (S) Stock price present value of cash flows expected from the investment
tion Exercise Price (X) present value of the fixed costs - incur over the life of the investment
Volatility (Sigma) std. dev. Of the future cash flows
Time to expiry (t) period for which the investment is held or valid
Dividends (d) dividend
Risk free rate (r) discount seyield on a riskless asset (like a government bond)

Exercise Price in real option is a fix **To give profit it should go over exercise Price/exercise price
Employee stock options:
Exercise price or strike price - and the employee will exercise his right only when stock price is higher than the exerc

Example:

Oil and gas block = 50 million of barrels of oil

and I can sell the oil for $50 per barrel

Inflows $ 2,500 million S

Investment $ 2,600 million X
NPV $ (100)

Given historical info is available on oil prices

and on exploration data

Volatility 30%
Maintenance cost(fixed cost) - regular basis - dividends

If we assume that 150 million, on maintaining block Value of option (181.11)

6.00% d1 0.26
d2 0.36
Time 5.00 years
Risk Free rat 5%
Ndi and ND2 are normal distribution function
ND1 How much proportion of shares
 Real Option
the investment PV Cash Inflows + option value increases
the investment Investment + Option value increases
Volatility
Project timeframe
dividend
Risk free rate

e is higher than the exercise or strike price

mal distribution function

h proportion of shares
Binomial option pricing models

Assumptions:
1. There are only two possible scenarios at each node of the binomial tree.
2. Two possible scenarios are up and down.
3. No dividends paid by the asset
4. Interest rate remains constant throughout the life of the option
5. Markets are considered frictionless - which means no transaction cost, no taxes

Investment = $80
Value of investment opportunity = $100
180 UP FACTOR (u) = 1.8
100 DOWN FACTOR (d) = 0.6
60 True Probability of an up move = 50%
True Probability of a down move = 50% Risk neutral probability?
Discount rate = 20%

100 120 is at the end of 1 year

Key thing - the risk has been incorporated in the denominator ( 1 / (1 + r)^n)

You can also factor in the risk in the numerator by using Risk Neutral Probability
Certainty equivalent models or risk neutral valuation

(50% x 180 + 50% x 60) / (1 + 20%) = 100 = (p x 180 + (1-p) x 60) / (1 + risk free rate)
p represents the risk neutral probability which may be different than true probabilities

Let's take an assumption of risk free rate of 4%

180p - 60p + 60 = 100 x 1.04

120p 44
p 36.7% 104.00
100.00

For a scenario where there is a truncation of payoff - you will have to use risk neutral valuation

Favourable development = value of the asset = 180

Payoff = 100 decision to invest
Unfavourable development = value of the asset = 60
Payoff = 0 decision to not invest

Option value = $ 35.26

1. with and without approach
2. black scholes
3. binomial
4. risk neutral valuation / certainty equivalent models
Risk neutral probability?