Evaluation of an Option to Defer: Case of a Tunisian Oil Reserve

31 Pages Posted: 9 Jul 2008

See all articles by Ben Said Hatem

Ben Said Hatem

University of Tunis - Faculty of Economic Sciences and Management (ESSEC)

Date Written: July 9, 2008

Abstract

The financial assessment of an oil project is a major problem for an oil company that makes investments involving a commitment of capital, labor and technology. Traditional methods of discounted cash flows have major weaknesses in evaluating such a project and which ignores the conditional aspect of certain investments and assume a passive behaviour on the part of leaders. In fact, the oil project is a project sequence that incorporates a portfolio of options. Thus, the exploration phase is described as an option to pay the expenses of exploration and receive reserves not developed. Once the economically exploitable reserves are proven, the concessionaire has an option to pay development costs by installing the productive capacity and receive the value of developed reserves. In this article, we will concentrate on reserves not developed since the development phase requires spending on the most important capital (the value of the development option is the most important). In our approach, we will assume that the exploration decision is taken immediately, but the option to defer the decision of development exists. In fact, we neglect the value of the option to defer the decision to exploration. Finally, during the production phase, the concessionaire may exercise the option to extract oil by paying the production costs and receive the price of crude oil. The objective of this article is to use the theory of evaluating options to develop a new approach for evaluating exploration projects and production. The evaluation of the option development will be made in a continues time through the model and Mc Donald Siegel (1986), which has practical benefits to other existing models for evaluating options, and is the model most mentioned in the literature of options for investments in oil, although a more complex model is also possible. The discrete-time evaluation will be made through the model of Pickles and Smith (1993) which is based on the binomial method described by Cox, Ross and Rubinstein (1979). The advantage of this model is that it does not require a high mathematical knowledge and provides an insight into how the value of the option is achieved when the exercise of an option is optimal. The empirical results suggest that the oil company must immediately develop its oil field, that is it must exercise its option to development in early 2007. Indeed, according to the rule optimal investment model Mc Donald and Siegel (1986), it does not invest when the gross value of the project exceeds the costs of development, but when the gross value of the project exceeds a certain critical value, knowing that this value exceeds the costs of development.

Note: Downloadable document is in French.

Keywords: real option, oil project, alternative development, rate of return of the reserve oil reserves not developed

JEL Classification: G11, G12, G13

Suggested Citation

Hatem, Ben Said, Evaluation of an Option to Defer: Case of a Tunisian Oil Reserve (July 9, 2008). Available at SSRN: https://ssrn.com/abstract=1157494 or http://dx.doi.org/10.2139/ssrn.1157494

Ben Said Hatem (Contact Author)

University of Tunis - Faculty of Economic Sciences and Management (ESSEC) ( email )

EL MANAR
Le Bardo 2000
TN
Tunisia

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