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

Abstract

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