Trigeorgis 1996 lists a whole range of managerial

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Unformatted text preview: interest Dividend Table 5.9: The similarities between a stock call al., 1988) UNDEVELOPED RESERVES Current value of developed reserves Development cost Relinquishment requirement Riskless rate of interest Net production revenue less depletion option and undeveloped reserves (source: Paddock et In practice, the key to applying options is in defining the options that are actually available to management. Trigeorgis (1996) lists a whole range of managerial options covering research and development and capital intensive industries, as well as oil and mining. Dixit and Pindyck (1994), the other classic text on real options, describes several oil applications, including sequencing decision-making for opening up oil fields and a study on building, mothballing and scrapping oil tankers. Since Brennan and Schwartz’s seminal work, many others have studied petroleum options. Copeland, Koller and Murrin (1990) for example, describe a case involving an option to expand production. Real option theory is best illustrated by an example. The following illustration is taken from Leslie and Michaels (1997). Suppose an oil company is trying to value its license in a block. Paying the license fee is equivalent to acquiring an option. The company now has the right (but not the 115 obligation) to invest in the block (at the exercise price) once the uncertainty over the value of the developed reserves (the stock price) has been resolved. Assume that the company has the opportunity to acquire a five-year license and that the block is expected to contain some 50 million barrels of oil. The current price of oil from the field in which the block is located is $10 per barrel and the cost of developing the field (in present value terms) is $600 million. Using static NPV calculations the NPV will be $500 million - $600 million=$-100 million. The NPV is negative so the company would be unlikely to proceed. The NPV valuation ignores the fact that decisions can be made about the uncertainty, which in this case is twofold; in the real world there is uncertainty about the quantity of oil in the block and about its price. It is, however, possible to make reasonable estimates of the quantity of oil by analysing historical data in geologically similar areas and there is also some historical data on the variability of oil prices. Assume that these two sources of uncertainty between them result in a 30% standard deviation around the growth rate of the operating cash inflows. Assume also that holding the option obliges the company to incur the annual fixed costs of keeping the reserve active, say $15 million. This represents a dividend-like payout of 3% (15/500) of the value of the asset. Using the Black and Scholes formula for valuing a real option δ ROV=Se - t * {(N(d1)} - Xe-rt * {(N(d2)) where, d1={1n(S/X)+(r-δ+σ2/2)t}/σ * √t, d2= d1-σ * √t, S=presented value of expected cash flows, X=present value of fixed costs, δ=the value lost over the duraction of the option, r=risk free interest rate, σ=uncertainty of expected cas...
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This document was uploaded on 03/30/2014.

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