An Integration of Real Options and Utility Theory for Evaluation and Strategic Decision-Making in Oil Development and Production Projects

Abstract The results from the Discounted Cash Flow (DCF) are limited as a tool for decision-making in the petroleum industry because they don't properly take into account four important features of the modern investments: uncertainty, irreversibility, timing, and corporation's risk-aversion. Recent developments in real options and preference theories have allowed decision-makers to employ these two approaches separately in the process of valuation and decision-making of risky projects. This paper presents a model for valuation and decision-making integrating discounted cash flow, real options and preference theory and aims at answering the following questions: i) What is the current value of an oil project? ii) What is the optimal working interest in this project venture? iii) What are the criteria to select projects considering investment irreversibility, uncertainty and timing to implement decisions? This model is applied to valuation and decision-making of a project to produce oil from a deep-water reservoir and its results are compared to those of the traditional approach. Traditional model suggests that, as the project value is above its investment cost, the corporation should invest immediately and incur in 100% working interest. Contrarily, for an specific analysis, the integrated model suggest the corporation should invest as long as project current value is as large as 1.85 times investment cost and should take only 44.38% working interest, whereas partners fund and acquire the remaining 55.62% of the project. In general, results indicate that NPV tends to pay more attention on return and does not account properly for risk. Then, as the uncertainty (volatility) of strategic variables increase, the two models give more divergent results.