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Unformatted text preview: ver 30 years of operation, one North Sea oil company accumulated a portfolio of license blocksfive-year rights to explore and produce oil and gas. Where net-present-value (NPV) analysis suggested that the eco- nomics were positive, the company drilled and developed the blocks. Where the blocks proved uneconomicas most did, usually because development costs were too high in relation to expected revenuesdevelopment was shelved. Left with unwanted blocks that were consuming cash (albeit very little) and that had limited investment appeal, the company decided to sell them to other companies that would buy them, cheaply, for reasons of geog- raphy or strategic fit. At one point in the divestment program, it was suggested to the companys managers that, instead of calculating what the blocks would be worth if the company started developing them immediately, it should value its opportunity as an option to develop if, at some point in the future, recoverable O Keith Leslie is a principal in McKinseys London office, and Max Michaels is an alumnus of the New York office. This article was originally published in The McKinsey Quarterly , 1997 Number 3. Copyright 1997 McKinsey and Company. All rights reserved. This article can be found on our Web site at www.mckinseyquarterly.com/corpfina/repo97.asp. Change the way you create value: The case for applying options thinking to any strategic situation. Keith J. Leslie and Max P. Michaels real options The real power of 97 reserves could be increased through the use of new drilling and production technologies. In other words, the managers should apply the notion of options, as conceived in financial markets, to their own business situation. A simple financial model showed the companys managers how to price blocks at their option value over five years, incorporating uncertainty about the size of the reserve and oil prices and leaving room for a flexible response to the outcome. The managers reevaluated the companys port- folio, and instead of letting blocks go for a notional amount, they decided to hold on to those with high option value and to sell or trade the rest at their revised worth. This case builds on the model developed for financial options by Fischer Black and Myron Scholes as modified by Robert Merton, 1 and specifically on the observation by Stewart Myers of the Massachusetts Institute of Technology that Black-Scholes could be used to value investment opportu- nities in real marketsthe markets for products and services. 2 The value of keeping ones options open is clearest in investment-intensive indus- tries, such as oil extraction, in which the licensing, exploration, appraisal, and development processes fall naturally into stages, each pursued or abandoned according to the results of the previous stage. Indeed, our work in the energy sector reveals that a number of excellent performers do instinctively or intuitively view their investment opportunities as real options, positioning themselves to tap possible future cash flows without...
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This note was uploaded on 01/29/2012 for the course FIN 6000 taught by Professor Banko during the Fall '11 term at University of Florida.
- Fall '11