Real Options, Sequential Bargaining Game and Network Effects in Natural Gas Production

59 Pages Posted: 22 Mar 2007

See all articles by Gordon Sick

Gordon Sick

University of Calgary - Haskayne School of Business

Yuanshun Li

Ryerson University

Date Written: March 15, 2007


This paper addresses a common problem in the petroleum industry, using techniques of real options in a cooperative game setting. It has the added twist of a network effect that encourages early development. In the model, two natural gas producers have adjacent undeveloped land with uncertain reserves. They must decide when to develop (drill and connect) their fields. In addition, one or both of them must build a gas processing plant to remove corrosive and toxic impurities, to make the gas suitable for entering a pipeline. Then, they must induce a pipeline company to build a gathering system to take their gas to market.

There is a real option for both producers to delay until they have suitable price and reserves conditions. But, there are incentives to be the first mover who can also build a gas plant to its own specifications and locational preference. This gives a first mover advantage that encourages early development. Also, there is a beneficial network effect from encouraging the follower to enter immediately and reduce the unit toll cost needed to induce the pipeline builder to enter. Thus, the first mover has to decide when to build, what capacity to build and what processing lease rate to offer the second mover. We believe that the problem is more general than the specific petroleum industry problem we model, insofar as it reflects a combination of real option theory to develop, coupled with competitive game theory between a leader and a follower in the development of a common-use asset and cooperative game theory between the leader and the follower to capture a network effect.

Keywords: real options, network effect, game theory, bargaining game, petroleum

JEL Classification: D43, G31, L13, L14, L71, Q40

Suggested Citation

Sick, Gordon and Li, Yuanshun, Real Options, Sequential Bargaining Game and Network Effects in Natural Gas Production (March 15, 2007). Available at SSRN: or

Gordon Sick (Contact Author)

University of Calgary - Haskayne School of Business ( email )

2500 University Drive, NW
Calgary, Alberta T2N 1N4
403-220-7165 (Phone)
403-282-0095 (Fax)

Yuanshun Li

Ryerson University ( email )

350 Victoria Street
Toronto, Ontario M5B 2K3
1-416-979-5000 ext. 6711 (Phone)
1-416-979-5266 (Fax)


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