ABSTRACT

The application of option pricing theory to the evaluation of capital investment decisions is rapidly gaining acceptance in the academic literature, and is being applied by some progressive organizations. The technique involves modelling the problem as a call option with the development cost being equivalent to the exercise price of a standard option such as that on a share of stock. The underlying asset is the reserve of oil being evaluated and its value is a function of oil prices. The volatility of oil prices and the convenience yield can be measured from oil futures price data and applied in the option context.

By using the binomial method, the problem is modelled as a large decision tree that determines the optimal decision, whether to develop or not, at each node of the binomial array. In addition, the minimum oil price at which development should occur at any point in time over the life of the option, or lease, can be determined. Binomial option pricing is a recursive certainty equivalent approach that allows the use of the risk-free rate of return, avoiding the need to arbitrarily specify a risk-adjusted discount rate. In the context of oil exploration, the method captures the value accruing to the owner of oil reserves during periods of rapid oil price increase.

This method is far superior to discounted cash flow methods when attempting to value projects with long lead times and high sensitivity to oil price fluctuations, such as exploration projects.

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