Offshore Petroleum Lease Evaluation under Uncertainty and Volatility Estimation Risk

16 Pages Posted: 10 Oct 2006 Last revised: 3 Dec 2008

See all articles by George Dotsis

George Dotsis

National Kapodistrian University of Athens - Faculty of Economics; Essex Finance Centre, Essex Business School, University of Essex

Vasiliki Makropoulou

Athens University of Economics and Business - Department of Management Science

Raphael N. Markellos

University of East Anglia (UEA) - Norwich Business School

Date Written: November 30, 2008

Abstract

Real options are now widely used in finance for the analysis of irreversible decisions under uncertainty. However, the applicability of this approach is typically limited by the fact that a key input, the volatility level, has to be approximated and estimated using only a handful of historical data or some proxy variable. This paper examines the practical implications of the resulting volatility estimation risk in finite and large samples by constructing confidence intervals for critical project values and options prices. We show that confidence intervals are asymmetric and hence investors that do not take into consideration estimation risk will tend to undertake projects precipitately. An empirical example in lease investment evaluation for an offshore petroleum tract shows that although the induced bias in the option values is likely to be small, the width of the relevant confidence interval can be substantial when a limited amount of data is used to estimate volatility.

Keywords: Real Options, Estimation Risk, Investment Evaluation, Uncertainty Aversion

JEL Classification: C44, D81, G31

Suggested Citation

Dotsis, George and Makropoulou, Vasiliki and Markellos, Raphael N., Offshore Petroleum Lease Evaluation under Uncertainty and Volatility Estimation Risk (November 30, 2008). Available at SSRN: https://ssrn.com/abstract=936067 or http://dx.doi.org/10.2139/ssrn.936067

George Dotsis

National Kapodistrian University of Athens - Faculty of Economics ( email )

Greece

HOME PAGE: http://sites.google.com/site/gdotsis/

Essex Finance Centre, Essex Business School, University of Essex ( email )

Wivenhoe Park
Colchester, CO4 3SQ
United Kingdom

Vasiliki Makropoulou

Athens University of Economics and Business - Department of Management Science ( email )

Evelpidon 47A & Lefkados 33
Athens GR-11362
Greece

Raphael N. Markellos (Contact Author)

University of East Anglia (UEA) - Norwich Business School ( email )

Norwich
NR4 7TJ
United Kingdom

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