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Real Options in Practice: Two Examples from the Energy Sector

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Real Options in Practice: Two Examples from the Energy Sector Real Options in Practice: Two Examples from the Energy Sector Sue Lisowski - Texaco Inc. DAAG (Decision Analysis Affinity Group) 2000 Calgary, Canada - May 17-19, 2000 Outline What is different about Real Options? Modeling options and managerial flexibility Valuing cash flows Example 1: New Technology Example 2: Offshore Opportunity Conclusion Why Real Options Valuation (ROV) ? Real Options Option Pricing Decision Simulation Trees (Monte Sensitivity Carlo) Discounted Analysis Cash Flow (DCF) Real Options Valuation (ROV) combines and extends DCF, Option Pricing, and Decision Analysis The two dimensions of Real Options Valuation Real Options Valuation (ROV) Discover Uncertainties, Valuing Cash Flows Options, & Flexibility (decomposed assessment) Open Framing Private vs. Market Risks Dynamic Learning Risk-free Discounting What are real options? Add Flexibility to Defer Project (Call Option) Rate Price Cost Rate Price Cost Develop Quit Develop Rate Price Cost Information Wait Quit Develop Information Wait Quit Year 1 Year 2 Year 3 Lease expires in 2 years What are real options? Add Flexibility to Abandon Project (Put Option) Salvage Salvage Value Value Abandon Abandon Rate Price Costs Develop Continue Continue Rate Price Costs Quit Develop Rate Price Costs Information Wait Quit Develop Information Wait Quit Year 1 Year 2 Year 3 Value cash flows with appropriate risking Use option pricing to model “market” (e.g., price) risk: Apply risk-adjusted probabilities to capture risk premium (can determine from futures and options markets) Use decision analysis to model “private” (e.g., volume) risk: Apply subjective probabilities to risk “non-tradable” assumptions (can determine from historical databases and expert assessments) Discount the resulting risk-adjusted cash flows at risk-free discount rate Who uses ROV?* Investment Banks Computer/Internet Energy /Consultants Telecommunication * partial list Learning Enhance subsequent decisions (option value) by incorporating learning on new information Learning occurs at differing speeds and in a variety of ways Learning Variance Revised Reduced estimate after drilling a 210 bbl/day well Probability Mean Value Shifted 3456 Log of Well Productivity (bbl/day) Graphs courtesy of ADA(PwC) ROV is not simply a better tool. It is an objective, all-embracing process. Decision Makers Continue Continue Action Open Framing Analysis Interpretation – Strategic Environment – “Smart” Modeling – “No regrets” Strategy – Uncertainties – Uncertainty Assessment – Dynamic Road-map – Options, Flexibilities – Market Pricing – Leveraging Uncertainties Asset Team + Real Options Other Experts Team Example 1: New Technology From commercial standpoint, relatively unproven technology More than one source of technology, with providers at differing points in development and experience Anticipate variations in technology performance and costs, depending on provider Questions Should we make a major commitment to this technology? What commercial opportunities exist for application of this technology in the long-term? In the short-term, on which commercial opportunities and technology provider(s) should we focus? How does commercial application of this technology look from a portfolio perspective? Areas of major uncertainty For each provider, technology effectiveness and cost For each provider and location, installation and operational costs Prices of inputs and end-products Potential for non-technical delays Contractual terms and taxes in various locations Decisions to be evaluated Which technology provider(s) should we use? Should we do more testing before committing to the technology? What implementation size is best? What implementation schedule is best? When should we take advantage of potential synergies? Approach taken Modeled approximately 10 separate opportunities Evaluated 3 separate schedules Treated as a “portfolio” of opportunities Placed significant emphasis on learning from project to project within each schedule Sources of option value Fully Risked base case is: •Technology Provider A •No exit •No synergy •Nominal project size •Base schedule Fully Risked Exit option Technology Project size Synergy Total Value "base" provider option option option Relative value of learning* With Options 100% 50% Without Options 0% Fully Learning Fully Fully Learning Fully Risked Value Risked Risked Value Risked Value, No Value Value, No Value Learning Learning * learning about technology, operating efficiency, operating costs, and capital costs Keeping all technology providers available is the best choice Expected Value A B C AB AC BC ABC No single provider is always the best choice For most opportunities, having a choice of technology providers is best Example 2: Offshore Opportunity Harsh or unique conditions May be little or no infrastructure in place Costs are higher Operations more difficult Large reserves Areas of major uncertainty Amount of oil and gas Recoverable oil and gas Drilling and platform costs Value of oil and gas Impact of delays Contractual terms, regulations, political issues, special environmental issues Decisions to be evaluated What size should the platform be initially? Should the platform be expandable? When should we expand the platform? How much? Should the development plan be rapid or staged? Should we handle production from other opportunities? Sources of option value Fully risked Platform Platform size Type of Total Value base location compl'n Optimal strategy map Delta Connect to Medium platform Large nearby platform platform Gamma Exit Medium platform Large platform Best Test Location Best Test Best Location Test Results = A Low Nominal High Test Reserve Results Results Calculations and Analysis Low Low Low Low Yes 1 Nominal Nominal Nominal Nominal No 0.9 High High High High 0.8 0.7 0.6 Low Low Low 0.5 Nominal Nominal Nominal 0.4 High High High 0.3 0.2 Low Low Low Low Low Low 0.1 Yes Opportunity Nominal Nominal Nominal Nominal Nominal Nominal 0 No workbook High High High High High High Model Building Expert Assessments Open Framing Session The long-term challenge is a cohesive, enterprise solution Strategy Execution Real Options Enterprise Risk Valuation Management Portfolio Value-Based Optimization Accountability.
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