A Real Option Perspective on Valuing Gas Fields

Tinbergen Institute Discussion Paper 13-126/VI/DSF60

54 Pages Posted: 29 Jan 2016

See all articles by Lin Zhao

Lin Zhao

Vrije Universiteit Amsterdam, School of Business and Economics

Sweder van Wijnbergen

Universiteit van Amsterdam; Tinbergen Institute; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Date Written: August 28, 2013


Real option theory has remained a fringe field; practitioners believe it is not practically applicable in complex real world environments. We show that this view is mistaken. We apply real option theory to a highly complex energy problem with unhedgeable risk, time varying volatilities and endogenous exercise dates (non-European options). Investment decisions in the energy industry are often undertaken sequentially and are sensitive to information on markets and geographic conditions. Information may arrive gradually over time and as a consequence of early stage decisions. Contrary to real option analysis (ROA), standard NPV-based frameworks are unsuitable because they do not allow for the fact that new information may change later stage decisions. We apply the approach to exploitation decisions for a Dutch cluster of gas fields, where gas prices and field reservoir size are the two main sources of uncertainty. Gas price returns show volatility clustering, which we model using a GARCH specification. Reservoir size uncertainty is unhedgeable, which necessitates an approach dealing with incomplete markets. Finally investment decisions can be postponed or delayed, which implies an non-European option setting, for which no analytical solutions exist. Correctly modeling the structure of volatility has a major impact: Option values shrink by 50% if the time varying nature of volatility is ignored. We also show that a high correlation between reservoir size at different locations creates large option values. The non-standard features of our approach have a major impact: option values are large so real options based valuations substantially exceed corresponding NPV calculations.

Keywords: real options, unhedgeable risks, volatility clustering, gas field valuation, pricing flexibility

JEL Classification: C61, G31, G32, Q4

Suggested Citation

Zhao, Lin and van Wijnbergen, Sweder, A Real Option Perspective on Valuing Gas Fields (August 28, 2013). Tinbergen Institute Discussion Paper 13-126/VI/DSF60. Available at SSRN: https://ssrn.com/abstract=2319251 or http://dx.doi.org/10.2139/ssrn.2319251

Lin Zhao (Contact Author)

Vrije Universiteit Amsterdam, School of Business and Economics ( email )

De Boelelaan 1105
Amsterdam, 1081HV

Sweder Van Wijnbergen

Universiteit van Amsterdam ( email )

Roetersstraat 11
Amsterdam, 1018 WB
+31 20 525 4011 / 4203 (Phone)
+31-35-624 91 82 (Fax)

Tinbergen Institute

Burg. Oudlaan 50
Rotterdam, 3062 PA

Centre for Economic Policy Research (CEPR)

United Kingdom

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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