The application of real option analysis on a Gas-to-Wire investment scenario
Master thesis Financial Engineering & Management University of Twente
Wouter J.A. van Heeswijk
Utrecht, 2012
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This is a dissertation submitted in fulfilment of the degree Master of Science in Industrial Engineering & Management.
Document properties
Author Wouter J.A. van Heeswijk Document type Master thesis
Study programme Industrial Engineering & Management Master track Financial Engineering & Management
University University of Twente Department School of Management & Governance
Host c ompany TNO Department Petroleum Geosciences Exam ination committee
First supervisor Dr. Reinoud A.M.G. Joosten University of Twente Sec ond supervisor Dr. Kuno J.M. Huisman Tilburg University External supervisor Ir. Christian F.M. Bos TNO
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Abstract
With this study, we aim to increase understanding of the insights that real option analysis (ROA) has to offer, particularly in comparison to dynamic decision tree analysis (DTA). We point out the fundamental theoretical shortcoming of applying a constant discount rate in the latter ap- proach, and explain how real options resolve this issue. Based on the fundaments of risk-neutral valuation and replicating portfolio concepts, we address different perspectives on how to treat non-hedgeable risks in a real option framework. We adopt an integrated view combining option pricing and decision analysis, which is theoretically consistent and allows an assessment of both market risk and private risk.
To illustrate the practical application of real option analysis, we construct a model which deter- mines the optimal time to switch from gas production to electricity generation directly at the wellhead (Gas-to-Wire). To deal with the path-dependent price paths in this investment prob- lem, we use a combination of Monte Carlo simulation and a backwards regression algorithm. We construct forecasting models for natural gas and electricity prices. These models deal with the seasonal effects, price jumps, mean-reversion and time-varying volatility observed particularly in electricity prices. With a comparative study, we show that ROA provides results that signifi- cantly deviate from those yielded by DTA. Keywords: real option analysis, private risk, path-dependent, Monte Carlo simulation, time se- ries analysis, Bermudan swap option, backwards regression, Gas-to-Wire
iv Glossary
Glossary financial theory
American option Option which can be exerci sed at any time du ring the life time of the o p- tion.
Arbitrage Opportunity to make a risk -free profit at zero cost, making use of pricing inconsistencies in the market.
Bermudan option Option which can be exercised at a number of pre -specified dates before maturity .
Black -Sch oles Formula used to calculate the arbitrage -free price of a European op tion formula under a set of restrictive assumptions.
Call option Derivative which grants the right to buy the underlying asset at a prev i- ously specified price .
Capital Asset Clas sic model used to estimate the return required by investors based on Pricing Model the risk -free interest rate and the correlation of the asset return with the prevailing market return.
Classic ROA Real option approach which relies on market replicat ion of the project , considering private risk as a source of tracking error.
Complete market Market model in which every financial asset can be replicated with a set of other financial assets, where all agents are able to trade all assets and no transactio n costs exists.
Convenience yield Benefits and costs stemming from possessing a commodity compared to holding its financial equivalent, caused by the opportunity to profit from tempo rary shortages and storage costs.
Decision Tree Method used to value a project with embedded flexibilities by incorpora t- Analysis ing decision points and proba bilities of different scenarios, using a co n- stant discount rate for all cash flows.
Derivative Financial instrument which derives its value from that of an underlying asset, with the payoff depending on the specified conditions.
Discounted Cash Method used to value a project by discounting future cash flows at a co n- Flow stant rate in order to obtain the net present value.
Discount rate Rate at which esti mates of futur e cash flows are discounted , reflecting the time value of money and risk -adjustment.
Diversification Reduction of risk by spreading investments, as such reducing the variance of the portfolio’s return. Perfect diversification leaves the investor e x- posed o nly to market movements.
European option Option which can only be e xercised at the end of its life time.
v Futures contract Contract which obliges to buy /sell an asset at a certain point in the future, with the price to be paid determined today.
Geometric Stochastic process to model the behaviour of asset prices over time , a s- Brownian Motion suming returns follow a normal distribution with constant parameters.
Hedging Practice to reduce risk exposure by taking an offsetting position to a sec u- rity. A per fectly hedged portfolio eliminates all market risk.
Heteroskedasticity Term to describe varying variance over time. Unconditional heteroskeda s- ticity does not depend on previous observations, conditional heterosk e- dasticity does.
Integrated ROA Real option approach which assumes that the market is partially complete, valuing the project part which can be replicated with arbitrage pricing and the remaining part with subjective valuation.
Leverage Increasing the potential return of an investment with debt or by using derivatives , at the cost of a higher risk.
MAD ROA Real option approach comparable to the subjective approach, assuming that the replicating portfolio is a twin security worth the subjectively e s- timated value of the project.
Market risk Part of project risks that can be replicated and hedged by financial instr u- ments under the assumption of a complete market.
Ornstein - Extension of Geometric Brownian Motion that incorporates mean - Uhlenbeck model reversion. As the simulated variable deviates more from its equilibrium level, the reverting effect becomes stronger .
Portfolio The collection of investments held by an investor, which may include all forms of financial instruments.
Private risk All project risks that cannot be hedged by market instrumen ts, formally defined as the tracking error of the replicating portfolio.
Put option Derivative which grants the right to sell the underlying asset at a prev i- ously specified price .
Real option Valuation method whi ch explicitly values flexibilities in real -world pr o- jects based on financial option theory .
Replicating Portfolio consisting of financial instruments, which replicates the payoffs portfolio of a real project in all market states and at all times.
Return Logarithm of the price at a certain time divided by the return of the prev i- ous time point, approximating the first difference of the price series over the specified interval.
Revised classic ROA Real option approach which applies either option pricing or decision analysis , depending on the dominating type of project risk.
vi Risk -free rate Theoretical rate which investors can earn without being subject to any risk. Often approximated by the return on government bonds with very low default risk.
Risk -neutral Valuation method wh ich assumes an artificial risk -neutral price distrib u- valuation tion, allowing to use the risk -free rate as drift of the underlying. Provides the same value as real valuation if the complete market assumption holds.
Security Term to describe a financial instrument, such as a stock, a bond or a d e- rivative.
Short -selling Selling assets borrowed from a third party, with the intention of buying back identical assets at a later time to return to the third party. This pra c- tice allows to profit from price decline without m aking an initial inves t- ment, but has an unlimited downside potential if not hedged.
Spot contract Contract to buy or sell an asset at the current time against the prevailing market price.
Subjective ROA Real option approach which assumes the subj ective estimate of the project value can be considered a replicating portfolio, using its NPV as basis for option valuation under the assumption of market completeness.
Swap option Option which grants the right to swap one stream of cash flows for a n- other stream of cash flows.
Time series Series of observations over a period of time, such as prices or returns.
Twin security (Hypothetical) s ecurity traded on the financial market that is perfectly correlated with the re al project.
Vašíček model Mean -reverting stochastic model to replicate the behaviour of the interest rate over time. Volatility Standard deviation of the return on an asset, being used as a measure of uncertainty of return.
Weighted Average Estimate for the average cost of capital, consisting of the cost of debt and Cost of Cap ital the cost of equity proportional to their share of total capital.
Glossary energy market
30/30 ambition Goal of EBN to have 30% of Dutch natural gas produced from small gas fields by the year 2030.
APX -ENDEX Dutch energy exchange, on which both short - and long -term contracts on natural gas and electricity are traded.
Balancing market Electricity market on which electricity is traded to correct for misbalances between supply and demand on the short term.
vii Connectivity Rate at which the gas -containing volumes in a field are connected to each other, allowing a gas flow towards the well.
Energie Beheer Dutch government -owned institu te, involved in every gas winning op er a- Nederland tion in the Netherlands as a facilitating partner. Also has an advisory task towards the Dutch government.
Expansion factor Indicates how much gas will expand when it is retrieved from the reservoir.
Gas -(Initially) -In - (Initial) amount of gas pr esent in a reservoir. Not all gas in a reservoir can Place be economically retrieved.
GasTerra Major gas trading institute in the Netherlands, co -owned by Shell, Exxon, EBN and the Dutch state. Has the public task to buy gas produced at small gas field s when r equested.
Gas Transport Full daughter company of Gasunie, responsible for the transport of natural Services gas through the main transport networks. Also performs conversion oper a- tions.
Gasunie Government -owned institute which owns and manages the Dutch main gas distribution network.
Gas intersection Planned function of the Dutch gas transport network to serve as a logistic centre for the transport and storage of natural gas in the north -west of Europe.
Groningen gas Major gas field located in th e province of Groningen. It is the largest natural field gas field in Europe and one of the largest in the world. Also referred to as the Slochteren gas field.
Line -packing Storing natural gas in the transport network under high pressure. Varying the pressure a llows to store less or more gas in the pipelines.
Natural gas Gas mixture containing hydrocarbons which has a high energetic value. It is found in underground reservoirs. Natural gas is used as an energy source both directly and as input to generate electricity. It is also used as feedstock in the chemical industry.
Nederlandse Aa r- E&P operator jointly owned by Shell and Exxon, being the largest natural dolie Maatschappij gas producer in the Netherlands and the sole exploiter of the Groningen gas field.
Nederlandse Competition regulator on the Dutch energy market, having the authority to Mededingings - enforce regulation on parties in the market. Also responsible for providing autoriteit licenses to market parties. Energiekamer
Net -to -gross ratio Part of the gross volume of a formation which can contain gas.
Permeability Rate at which natural gas can flow through the porous rock formation.
Porosity Percentage of a formation which can contain fluid or gas.
viii Reserve Economically retrievable amount of gas in a reservoir .
Saturation Percentage of porous volume in a formation filled with gas.
Small fields policy A Dutch government policy to stimulate the development of small gas fields in order to reduce the burden on the Groningen gas field. The pol icy co m- prises a guaranteed sale of production, and fiscal advantages for projects at the North Sea.
Spark spread Difference between the price of electricity and the price of the amount of input fuel required to generate the same amount of electricity.
Ta il -end gas field Gas field which is in a mature state of exploitation.
TenneT Government -owned institute which owns and manages the Dutch electri c- ity high -voltage transport network.
TTF Virtual trading point for natural gas, which is facilitated by energ y e x- change APX -ENDEX.
Tubing Tube placed in the well through which the gas flows from the reservoir to the surface. The diameter of the tubing determines the pressure and the friction level within the well.
Virgin gas field Currently unexploited gas fiel d containing a small amount of gas .
Volume Gross volume of the formation containing gas, measured by multiplying the area of the formation with its thickness . Acronyms and abbreviations
AC Autocorrelation .
ADF Augmented Dickey -Fuller .
APX Amsterdam Pow er Exchange .
AR Autoregressive .
ARMA Autoregressive Moving Average
ARIMA Autoregressive Integrated Moving Average .
CAPM Capital Asset Pricing Model .
DCF Discounted Cash Flow .
DTA Decision Tree Analysis .
EBN Energie Beheer Nederland .
EBT Earnings Be fore Taxes .
ENDEX European Energy Derivatives Exchange .
EPCCI European Power Capital Cost Index .
ix EWMA Exponentially Weighted Moving Average .
E&P Exploration and Production .
GARCH Generalized Autoregressive Conditional Heteroskedasticity .
GBM Geometri c Brownian Motion .
GIIP Gas -Initially -In -Place .
GIP Gas -In -Place .
HC High -caloric gas .
LC Low -caloric gas .
MA Moving Average .
MAD Market Asset Disclaimer.
MWh Megawatt hour .
NAM Nederlandse Aardolie Maatschappij .
NGL Natural Gas Liquid .
NMa Neder landse Mededingingsautoriteit .
NPV Net Present Value .
PAC Partial Autocorrelation .
PRP Programme Responsibility Partner .
ROA Real Option Analysis .
UCCI Upstream Capital Cost Index .
UOCI Upstream Operating Cost Index .
VAR Vector Autoregressive .
VEC Vector Error Correction .
WACC Weighted Average Cost of Capital . Mathematical notations used