2. Structure presentation
The importance of DA
Value of flexibility
Risk types
Decision trees
Real options
Wrap up
3. A new reality:
the high oil price is here to stay
٠ The E&P industry is slowly coming to terms with a new reality, after two
decades during which oil prices fluctuated around $25 per barrel: the
present high oil price is here to stay.
Brent spot price
100
90
80
70
USD/bll
60
50
40
30
20
10
0
02/01/1986
02/01/1988
02/01/1990
02/01/1992
02/01/1994
02/01/1996
02/01/1998
02/01/2000
02/01/2002
02/01/2004
02/01/2006
Source: Energy Information Administration
4. High energy demands drives
high risk investments
٠ Unprecedented energy demand
٠ A key driver for the all-time high oil prices is a global increase in the
demand for energy.
٠ Unprecedented high risk investments
٠ In order to satisfy this demand the E&P industry has intensified their
search for Greenfield opportunities and initiated a large number of
highly technical challenging projects.
٠ The investments and risks associated with these projects are
unprecedented
٠ …..hence the need for high quality DA processes
5. DA process as a key success factor
٠ Decision making as competitive advantage
٠ Differentiation in technologies and data collection is difficult
٠ A competitive advantage can be achieved by superior data management
and decision making processes
٠ Decision analysis is ultimately driven by economic metrics
6. The challenge of
accurate decision making
Enhancing the turnaround time and
accuracy invariably
means more consistency.
complexity
7. The accepted practise of
risk modelling
٠ Enhanced financial modelling
٠ The oil and gas industry has started to realise the value of enhanced
financial modelling.
• Probabilistic modelling
• Monte Carlo simulations
٠ However, the value of flexibility is rarely recognised as a key value driver.
8. Structure presentation
The importance of DA
Value of flexibility
Risk types
Decision trees
Real options
Wrap up
9. Reacting on unfolding uncertainty:
The concept of optimisation
Decision one:
To drill or not
Drill well Build platform Oil sales
Decision two:
Build platform if
drill is successful
10. NPV’s major restraint:
Capitalising on the value of flexibility
٠ Modelling uncertainty
٠ Economic results are typically presented as expected net present values
and probability distributions.
٠ The failure to react on new information
٠ The net present valuation method assumes that once an investment is
made, the project will run its course without intervention.
11. Managing uncertainty:
Investing in options
٠ Managing uncertainty
٠ Decision makers manage uncertainty by evaluating different feasible
outcomes and plan for fall-back opportunities.
٠ Modelling uncertainty management
٠ Decision tree analysis and real option valuation.
12. An example of optimisation
No optimisation procedure
Oil Build platform Oil sales
Drill well 50% ($40) $100
No oil Build platform Oil sales
50% ($40) $0
ENPV = 50% * (-$40 + $100) + 50% * (-$40 + $0) = $10
Optimisation procedure
Oil Build platform Oil sales
Drill well 50% ($40) $100
No oil Do not build platform Oil sales
50% $0 $0
ENPV = 50% * (-$40 + $100) + 50% * ($0 + $0) = $30
13. Structure presentation
The importance of DA
Value of flexibility
Risk types
Decision trees
Real options
Wrap up
14. Two sources of risk:
Market - and technical risk
٠ For the purpose of risk optimisation a distinction is made
between market- and technical risk
٠ These risks have different characteristics and require
different modelling techniques
٠ Decision tree analysis and real option valuation
15. Market - and technical risk:
Characteristics
٠ Risk control
٠ Technical risk is, within limits, controlled by the assets
owner
٠ Market risk is outside the control of the assets owner
٠ Risk mitigation
٠ Technical risk can be mitigated by investing in a large
portfolio of assets.
٠ Market risk will affect the entire portfolio
16. Market - and technical risk:
Risk modelling
٠ Total number of possible outcomes
٠ Market risk often have a very large number of possible
outcomes
٠ Technical risk is typically resolved in a limited number of
possible outcomes
17. Examples of
Market – and technical risk
Technical risks Market risk
Geological uncertainty Hydrocarbon price
Downtime operations Fiscal terms
Drilling Geopolitics
Capital investment Rig rates
18. Structure presentation
The importance of DA
Value of flexibility
Risk types
Decision trees
Real options
Wrap up
19. Decision tree valuation
٠ Modelling technical risk
٠ The impact of technical risk is addressed by developing a series of
scenarios.
٠ Risk optimisation in a decision tree is achieved by making an optimal
choice an uncertainty is resolved.
٠ Modelling market risk
٠ Market risk is accounted for by a risk premium which is incorporated in
the discount rate.
٠ Thus no risk optimisations opportunities are modelled that relate to the
resolving of market uncertainty during the completion of a project.
20. Decision tree valuation:
An example
٠ Assume an exploration project
٠ With uncertain future production volumes
٠ In which a processing plant has to be constructed
• There is a choice between
– an expensive efficient large plant
– and a cheaper but less efficient plant
• The decision which plant to build can be postponed after the
uncertainty regarding the production volumes is resolved
21. Decision tree modelling: assessing different scenarios
Incremental
No. bll Revenue Investment NPV
revenue
Large plant
Low case reserves
100 bll 2 $/bll 200 $ (250 $) (50 $)
25% Small plant
100 bll 0.5 $/bll 50$ (50 $) 0$
Large plant
Mid case reserves 150 bll 2 $/bll 300 $ (250 $) 50 $
50% Small plant
150 bll 0.5 $/bll 75$ (50 $) 25 $
Large plant
High case reserves
250 bll 2 $/bll 500 $ (250 $) 250 $
25% Small plant
250 bll 0.5 $/bll 125$ (50 $) 75 $
22. Decision tree modelling: optimisation and roll back
NPV
Low case reserves Large plant
0$
(50 $)
25% Small plant Max((50 $),0$)
0$
Mid case reserves Large plant
87.5 $ 50 $ 50 $
Max(50 $,25 $)
50% Small plant
25 $
High case reserves Large plant
250 $
250 $
25% Small plant Max(250 $, 75 $)
75 $
23. Comparison of results
Large plant Small plant
Low case reserves Low case reserves
25% (50 $) 25% 0$
75 $ Mid case reserves 31.25 $ Mid case reserves
50% 50 $ 50% 25 $
High case reserves High case reserves
25% 250 $ 25% 75 $
Optimisation Large/ small plant
Low case reserves
25% 0$
87.5 $ Mid case reserves
50% 50 $
High case reserves
25% 250 $
24. Structure presentation
The importance of DA
Value of flexibility
Risk types
Decision trees
Real options
Wrap up
25. Real option valuation
٠ Modelling market risk
٠ A mathematical process describes a range of gross project values at
timex and the development of the range over time.
٠ Given a project value at timex, an optimal decision is made whether or
not to proceed with the project.
٠ There is no need for a risk premium in the discount rate because market
risk is explicitly modelled.
٠ Modelling technical risk
٠ Development of a series of scenarios as is done in decision tree
analysis.
26. Real option valuation using the
Binominal approach
٠ Modelling a range of asset values with the binominal ROV
٠ At time zero the value of an asset has a certain value, when moving
from period zero to period one this value can increase or decrease with
an equal likelihood
٠ The change occurs as a discrete jump
٠ The jump process is repeated when moving from period one to period
two, and continues going forward into the future. Over time a range of
possible outcomes are generated
29. Binominal Real Option Valuation:
Building a lattice
t0 t1 t2 t3
Value Cost
131 100
123
110 110 100
100 100
90.9 90.9 100
82.6
75.1 100
30. Binominal Real Option Valuation:
Optimisation
t0 t1 t2 t3
Value
Max(131-100,0)
Max(110-100,0)
Max(90.9-100,0)
Max(75.1-100,0)
31. Binominal Real Option Valuation:
Optimisation
t0 t1 t2 t3
Value
Max(131-100,0)
Max(110-100,0)
Max(90.9-100,0)
Max(75.1-100,0)
32. Binominal Real Option Valuation:
Discounting
t0 t1 t2
Value
p 31/(1+0.015)
1-p
p 10 /(1+0.015)
1-p
p 0 /(1+0.015)
1-p
0 /(1+0.015)
P = Risk neutral probability
33. Binominal Real Option Valuation:
Rolling back the tree
t0 t1 t2
Value
30.5
0.55*30.5 + 0.45*9.85
9.85
0.55*9.85 + 0.45*0
0
0.55*0 + 0.45*0
0
34. Binominal Real Option Valuation:
Discounting and roll back
t0 t1 t2
21.2
(0.55*21.2+0.45*5.4)/(1.015)
5.4
(0.55*5.4+0.45*0)/(1.015)
0
35. Binominal Real Option Valuation:
Discounting and roll back to period 1
t0 t1 t2
21.2
13.9
5.4
2.94
0
36. Binominal Real Option Valuation:
Discounting and roll back to period 0
t0 t1
13.9
(0.55*13.9+0.45*2.94)/(1.015)
2.94
37. Binominal Real Option Valuation:
Determine the option value
t0
The option value is finally obtained when the
tree is discounted and rolled back to period 0.
The real option value is 8.85
8.85
38. Comparison of results:
Optimisation versus no optimisation
Optimisation No optimisation
t0 t1 t3 t4 t0 t1 t3 t4
31 31
21.2 21.2
13.9 10 12.1 10
8.8 5.4 3.8 1.4
2.9 0 -6.2 -9.1
0 -15.6
0 -24.1
39. Note of warning!
٠ Several Real Option Valuation techniques have been proposed
٠ The binominal method is easy to explain but has some important
limitations and its use is therefore not recommended
٠ Technique like the Least Square Mean Option Valuation are much more
suited.
40. Structure presentation
The importance of DA
Value of flexibility
Risk types
Decision trees
Real options
Wrap up
41. The value of flexibility is
project specific
٠ Value of flexibility
٠ Value metrics typically increase when risk optimisation is introduced in
an economic model.
٠ The value added to the asset, the value of flexibility, is project specific
and is determined by
• the flexibility associated with the project
• and the structure of the cash flow.
42. The right tool for the job…
Real
Combined Real Options and
Options
decision tree analysis
analysis
Flexibility
Market NPV Decision tree analysis
risk
Technical risk
43. Some projects and their preferred
economic tool
ROV: ROV/D-tree:
Brownfield Greenfield
project exploration
project
Market
risk
Deterministic D-tree:
analysis:
Project with
Brownfield contracted oil
project price
Technical risk
45. Modelling risk optimisation:
The Prize
٠ Project Value
٠ A project with a staged investment and multiple exit points before the
final investment has to be made typically has a large value of flexibility.
• A deterministic net present value of such a project will significantly
underestimate the true economic value.
٠ Project differentiation
٠ Projects that cannot be differentiated on the basis of deterministic net
present values will yield different decision tree values and projects with
equal decision tree values can be differentiated using real option
valuation.
51. Resolvable versus Irresolvable Risk
٠ Resolvable risk relate to uncertainties that will be resolved during the early
stages of a project, during which investments are made
٠ Irresolvable risk refer to uncertainties that persist until all of the investment
has been made.
٠ The value of managerial flexibility is restricted to resolvable risk
Project progression
Investment
Information flow unravelling Information flow unravelling
resolvable risk irresolvable risk
52. Value drivers in an uncertain world
Increasing value Cost and time
uncertainty
of flexibility American American
options options
Compounded Compounded
options options
Sales Sales Sales
volatility volatility volatility
CoS CoS CoS CoS
NPV Decision Black & Binominal LSM ROV
tree Scholes