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 Graphs courtesy of ADA(PwC)

Probability Log ofWellProductivity (bbl/day) 3456 Reduced Variance Shifted Value Mean Learning 210 bbl/day well estimate after estimate drilling a Revised 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