Abstract

Option pricing techniques (OPT) are financial valuation tools that estimate the net present value of upside opportunities associated with uncertainty. Equity traders have used options for many years and a mathematical formalism has arisen to estimate their value. When the uncertainty is large and the time to resolve the uncertainty is sufficiently long, an option may be large.

The energy industry is built upon development and exploitation of large capital projects that have many opportunities during the life of the project to capture upside value and to limit exposure to the downside. Traditional discounted cash flow (DCF) analysis may not adequately characterize the opportunities. Managing these investments requires managing the uncertainties of cost, commodity price, production profiles, market capacity, and the value of incremental knowledge. The industry manages these uncertainties by making incremental investments that exploit increasing knowledge of the opportunity. This is particularly true for investments with break-even economics or with lifetimes more than twenty-five years. Estimating a potential value of future incremental investment opportunities embedded in large capital projects can be done using OPT. The incremental value recognized by OPT reflects management ability to adjust project scope, investment rate, production rates, etc., to accommodate uncertainties related to price, market, and resource availability.

Mobil is extending OPT to capital budgeting to improve its long term project valuations, manage technology applications, and optimize investment timing. This article discusses some extensions made to OPT for capital budgeting issues, illustrates its application to a development program, and suggests opportunities for applications in the industry.