Real Options As Valuation and Decision Making Tool in Upstream Projects

REAL OPTIONS AS VALUATION AND DECISION MAKING TOOL IN
UPSTREAM PROJECTS

Andika Rivai

in Partial Fulfillment of the Requirements for the Dual Degree of

MBA / MSc in Financial Management

THESIS

pg. 2

Executive Summary
This thesis consists of 10 chapters. Chapter 1 covers the purpose, background information, methodology,
and structure of the thesis. The value chain will be discussed in Chapter 2. Chapter 3 to Chapter 7 introduced
the tools needed to solve the case study. Case study and proposed solution presented in Chapter 8 and 9.
Finally, Chapter 10 is concluded the study.
To understand investment decisions, one need to understand the industrys value chain. Chapter 2
analyzed value chain in upstream petroleum industry, they are: (1) prospect, (2) exploration and appraisal,
(3) development, (4) production, and (5) abandonment.
Chapter 3 starts by explaining how the stochastic process can be used to forecast the oil price. Simply put,
a stochastic process is a mathematically defined equation that can create a series of outcomes overtime,
outcomes that are not deterministic in nature. Two stochastic process approaches: (1) brownian motion and
(2) mean-reverting will be discussed.
Chapter 4 revisited classical valuation approach of oil and gas properties. In an oil and gas environment, the
assumption of perpetuity is not realistic, thus a cash flow forecast should run for the entire life of the asset
being valued. To accurately forecast the free-cash-flow-to-the-firm, a proper financial model is needed.
The financial models consist of (1) profit loss, (2) balance sheet, (3) cash flow, and (4) valuation.
Since the financial model produced only a single-point estimate result, Chapter 5 presented Monte Carlo
simulation as a tool to get a set of probable outcome. Monte Carlo simulation is undertaken by modelling a
project and its key factors affecting the profitability of the project. Using @RISK software, a simulation can be
done as many times as possible to plot a frequency distribution of the outcomes.
Chapter 6 talked about decision tree analysis. In contrast to Monte Carlo simulation which evaluate pre-
determined project scenarios, decision tree focus on managerial decisions. Decision tree also take account
of uncertainty, but they do so in a more rudimentary way, typically, by specifying the probabilities of limited
classes such as large, small or zero.
Still, either simulation or decision analysis could not capture value of flexibility like real options. However,
the models described in the real options literature often greatly oversimplify the problems. The integrated
approach presented in Chapter 7 tried to bridge this gap by noting that there are two types of risk associated
with most corporate investments: public (non-diversifiable) and private (diversifiable). It presented an
approach that covered traditional decision analysis at one extreme to option pricing at the other.
To illustrate where real options analysis can be used to add value in valuation and decision making process,
a case study will be introduced in Chapter 8. This case is based on generalized experience, with a fictional
story and characters, but the salient features resemble the development of Ivar Aasen field in the North Sea.
Chapter 9 offered practical solution that demonstrates the possibility of actually implementing real options
valuations in a meaningful way by an analyst.
Chapter 10 presented an important conclusion: the integrated approach resulted with a probability
distribution that combines real options, diversifiable risk, and non-diversifiable risk effects: The right-hand
side of the distribution has fatter tails (upward potential), while losses on the downside are clearly cut off.

pg. 3

Contents
Executive Summary ........................................................................................................................................ 2
Chapter 1 Introduction .................................................................................................................................... 5
Methodology ................................................................................................................................................. 6
Target Group ................................................................................................................................................ 7
Delimitation ................................................................................................................................................... 7
Structure ....................................................................................................................................................... 8
Chapter 2 Upstream Petroleum Industry ..................................................................................................... 9
Prospect ........................................................................................................................................................ 9
Exploration and Appraisal .......................................................................................................................... 9
Development .............................................................................................................................................. 10
Production .................................................................................................................................................. 10
Abandonment ............................................................................................................................................. 10
Petroleum Economics ............................................................................................................................... 11
Chapter 3 Stochastic Forecasting ............................................................................................................... 12
Oil Price ...................................................................................................................................................... 12
Stochastic Process .................................................................................................................................... 13
Brownian-Motion ........................................................................................................................................ 13
Mean-Reverting Price Model ................................................................................................................... 14
Chapter 4 Valuation of Oil and Gas Properties ........................................................................................ 15
Income (DCF) Approach .......................................................................................................................... 15
Practical Issues .......................................................................................................................................... 16
Financial Modelling ................................................................................................................................... 17
Chapter 5 Monte Carlo Simulation ............................................................................................................. 18
Sensitivity Analysis .................................................................................................................................... 19
Chapter 6 Decision Tree .............................................................................................................................. 20
Options ........................................................................................................................................................ 21
Chapter 7 Valuing Flexibility, Real-Options ............................................................................................... 23
Real-Options .............................................................................................................................................. 24

pg. 4

Methods for Valuing Flexibility................................................................................................................. 25
Real-Option Valuation (ROV) .............................................................................................................. 25
Decision Tree Analysis (DTA) ............................................................................................................. 25
Underlying risk: Diversifiable versus Non-Diversifiable ................................................................... 25
The Integrated Approach ......................................................................................................................... 26
Chapter 8 Case Study Kukuza Offshore Oilfield ...................................................................................... 27
Introduction ................................................................................................................................................. 27
Prospect ...................................................................................................................................................... 28
Exploration and Appraisal ........................................................................................................................ 29
Development .............................................................................................................................................. 30
Production .................................................................................................................................................. 33
Abandonment ............................................................................................................................................. 34
Economics .................................................................................................................................................. 35
Case Questions ......................................................................................................................................... 37
Chapter 9 Proposed Solutions .................................................................................................................... 38
Discount Rate ............................................................................................................................................ 38
Forecasting Oil Price ................................................................................................................................ 39
Traditional Valuation Model ..................................................................................................................... 42
Monte Carlo Simulation ............................................................................................................................ 45
Decision Tree ............................................................................................................................................. 48
Scenarios .................................................................................................................................................... 50
Valuing Flexibility ....................................................................................................................................... 51
Chapter 10 Conclusion ................................................................................................................................. 54
Works Cited .................................................................................................................................................... 60
List of Figures and Tables ............................................................................................................................ 62
Appendix ......................................................................................................................................................... 64
About the author ............................................................................................................................................ 77

pg. 5

Chapter 1 Introduction
A growing number of managers and academics are becoming convinced that the traditional approaches to
valuation are inadequate since they do not properly capture managerial flexibility to adapt and revise later
decisions in response to unexpected market development.
Insight and techniques derived from option pricing
1
enable the quantification of elements of managerial
flexibility and strategic interactions, which have thus far been ignored or underestimated by standard net
present value (NPV) or discounted cash flow (DCF) methods.
The value of flexibility and thus the real option value of a project are at their greatest when there is
considerable uncertainty about the future and much room for managerial flexibility. Real option is especially
relevant for grey zone projects/ NPV near zero as including value of managements options may affect the
ultimate decision to invest.
Since the mid-1990s Real Options began to attract attention from industry as an important tool for both
valuation and strategy. Beginning principally in the Oil and Gas industry, and extending to a range of other
industries, consultants and internal analyst started to apply this concept to major corporate investments.
Managements flexibility to revise its future actions in response to future market circumstances expands an
investment opportunitys value by improving its upside potential and limiting downside losses relative to
initial expectations under passive management. The resulting asymmetry caused by managerial adaptability
calls for an expanded NPV rule that reflect both value components: the traditional (static or passive) NPV of
direct cash flows and the option value of this flexibility
(Maeseneire, 2006)
Oil and Gas Industry is ideally suited for a real options-type analysis because the companies exhibit all the
necessary ingredients:
Large capital investments.
Exclusivity (once lease of oil/ gas assets secured)
Uncertain revenue streams (sensitive to oil price).
Often long lead times to achieve these uncertain cash flows.
Reserves uncertainty (reservoir size and quality).
Numerous technical alternatives at all stages of development.
Political risk and market exposure.
(Bailey, 2006)

The objective of the thesis is to (1) argue that traditional approaches to valuation are inadequate, (2)
highlights the importance of Real-Options analysis as valuation and decision making tool, and (3) Investigate
the practical approach of Real-Options model in an upstream projects.

1
From 1970s onward, the financial world began developing contracts called puts and calls which give their owner the
right but not the obligation to sell or buy a specified number of shares or a quantity of a commodity such as gold or oil, at
or before a specified date.

pg. 6

Methodology
To illustrate where real options analysis can be used to add value in valuation and decision making process,
a case study will be performed. This case is based on generalized experience, with a fictional story and
characters, but the salient features resemble the development of Ivar Aasen field in the North Sea.
The case study mostly uses the eight-step integrated risk management process developed by (Mun J. ,
2006), except for step no.6, where this thesis use an integrated approach, to capture both diversifiable and
non-diversifiable risks. This approach is the integration of option pricing and decision analysis, and is a
modification from the one described by Smith and Kevin McCardle. (James E. Smith, 1999)

FIGURE 1 INTEGRATED RISK MANAGEMENT PROCESS
Qualitative Management screening
Qualitative management screening is the first step in any integrated risk analysis process. Decision makers
have to decide which projects, assets, initiatives, or strategies are viable for further analysis, in accordance
with the organizations overall business strategy.
Time-series and stochastic forecasting
The future is then forecasted using time-series analysis, stochastic forecasting. Most of the real options
literature assumes the oil price follows a random walk, specifically geometric Brownian motion. To capture
the phenomenon of mean reversion, we will also discussed a mean-reverting stochastic process for oil prices
where future prices are expected to drift back to a specified long-run average price (Avinash K. Dixit, 1994).
Base case Net Present Value analysis
Using the forecasted values in the previous step, a discounted cash flow model is created. This model serves
as the base case analysis where a net present value or NPV is calculated. This NPV is calculated using a
discount rate that reflects cost of capital and desired rate of return.
Monte Carlo simulation
Because the static discounted cash flow produces only a single-point estimate result, there is oftentimes little
confidence in its accuracy. To better estimate the actual value of a particular project, Monte Carlo simulation
should be employed next.
A sensitivity analysis is first performed on the discounted cash flow model. We can change each of precedent
variables (such as revenues, operating expenses, capital expenditure) and note the change in NPV. A
tornado chart is then created, where the most sensitive precedent variables are listed first. Using this
information, we then decide the key variables that will be processed with Monte Carlo simulation. This step
models, analyzes, and quantifies the various risks of each project. The result is a distribution of the NPVs
and the projects volatility.
1. Quantitative
Management
Screening
2. Time-series
and stochastic
forecasting
3. Base Case
Net Present
Value Analysis
4. Monte Carlo
Simulation
5. Real Options
Problem
Framing
6. Real Options
Modeling and
Analysis
7. Portfolio and
Resource
Optimization
8. Reporting
and Update
Analysis

pg. 7

Real options problem framing
The risk information obtained in previous steps needs to be converted into actionable intelligence, and use
real options analysis to hedge, value, and take advantage of these risks. The first step in real options is to
generate a strategic map or event trees.
During this process, certain strategic optionality would have become apparent. This may include option to
expand, contract, abandon, switch, choose, and so forth. In this step flexibility is incorporated into event
trees, which transforms them into decision trees
2
.
Real options modeling and analysis use integrated approach
There is a concern that the models described in the real options literature greatly oversimplify the problems
they actually face. The integrated approach begins by noting that there are two types of risk associated with
most corporate investments: public (non-diversifiable) and private (diversifiable). The integrated approach
acknowledges this and it is designed to address that very situation.
The integrated approach involves the following steps: (1) Build a decision tree, (2) Identify each risk as either
public of private, (3) Assign subjective probabilities for private risks, (4) Apply a spreadsheet cash-flow model
at each tree end point, (5) Roll back the tree to determine optimal strategy and its valuation, (6) Perform
Monte Carlo simulation for public risks in the decision tree, the result will be different sets of optimal strategy
for different circumstances, and a distribution of real options valuation.
Portfolio and resource optimization
Portfolio optimization is an optional step in the analysis. If the analysis is done on multiple projects, decision
makers should view the results as a portfolio of rolled-up projects because the projects are in most cases
correlated with one another, and viewing them individually will not present true picture. This step is not
performed in this thesis since there is only one project to evaluate.
Reporting and update analysis
Create clear, concise, and precise reporting materials.
Target Group
The emphasis in this thesis on valuation and decision making in upstream projects makes it especially
interesting for professionals in petroleum industry. Professionals referred in here are not only the decision
makers (management), but also the financial analyst who support the decision making process. The thesis is
also relevant for students with a more general interest to understand reasoning behind Real-Options
valuation. This does not imply that the thesis can be easily understood without basic familiarity and
knowledge in finance, decision-analysis, and offshore petroleum project.
Delimitation
The case study is based on various sources of information. The aim of the analysis is to construct a realistic
but simplified valuation of an offshore oil development in the North Sea. Assumptions taken in the case study
may be wrong or misleading; however, the utility of the analysis should not be affected by the possibility of
wrong assumptions being used as input in the decision analysis and valuation.

2
A graphical tool developed to represent complex decision problems. Decision trees clearly shows the sequence of
events (decisions and outcomes), as well as probabilities and monetary values.

pg. 8

Structure
In table 1 below, the Author outline the plan of the thesis and give a flavor of some important ideas and
results that emerge from the analysis.

Introduction

To illustrate where real options analysis can be used to add value in valuation and decision
making process in upstream projects, this thesis use 8-steps integrated risk management
approach (Mun J. , 2006). The objective is to illustrate practical application of this concept.

Upstream
Petroleum
To understand investment decisions, we need to understand the industrys value chain. A brief
chain analysis of upstream petroleum industry will be presented.

Finance
Theory
Then literature studies: (1) Stochastic Forecasting, (2) Valuation of Oil and Gas Properties, (3)
Monte Carlo Simulation, (4) Decision Trees, (5) Valuing Flexibility, Real-Options

Case:
Kukuza
Offshore
Oilfield

The story starts with a kick-off meeting to prepare production license application of Field
Alpha. Ben, recently hired as Finance Manager, will be responsible for the overall economics
of the project. The case study will consist of: (1) Introduction, (2) Prospect, (3) Exploration and
Appraisal, (4) Development, (5) Production, (6) Abandonment, and (7) Economics.

Proposed
Solutions
(A) Predicting future oil price is very difficult and is the weakest link in upstream project
valuation process. So, how do we forecast the oil price? Well discuss two stochastic
approaches: (1) brownian motion and (2) mean-reverting.

(B) After oil price forecasted, Ben start with traditional valuation model for the upstream
projects. To give a clear picture, well discuss: (1) Profit Loss, (2) Balance Sheet, and (3)
Cash Flows. Well also discuss (4) Net Present Value and (5) Adjusted Present Value.

(C) Monte Carlo Simulation is then used to get a set of probable outcome, by simulating
probability distributions of current DCF model.

(D) Different strategic options available to the company will be discussed. Focus will be on (1)
option to continue with Field Alpha only. (2) Option to expand to Field Bravo and Field
Charlie, and (3) option to abandon the project.

(E) Based on COO explanation about sequence of events with possible outcome: (1) Generate
a strategic map or event trees. (2) Decide what strategic options to choose and when. (3)
Incorporate the events and strategic options into the decision tree.

(F) After constructing decision tree, Ben find out that there are 13 different scenarios that
represent sequence of events and probable outcomes of diversifiable risk (i.e. size of
reservoir and managerial flexibility (option to expand, continue, or abandon).

(G) He then again runs Monte Carlo simulation to account non-diversifiable risk (i.e. oil price).
After simulation, we will get a probability distribution that combines real options,
diversifiable risk, and non-diversifiable risk effects: The right-hand side of the distribution
has fatter tails (upward potential), while losses on the downside are clearly cut off.

TABLE 1 THESIS STRUCTURE

pg. 9

Chapter 2 Upstream Petroleum Industry
Understanding investment decisions in the upstream petroleum industry requires an understanding of the
industrys value chain. Value chain analysis can be used in terms of understanding how projects are
structured. See figure 2.

FIGURE 2 VALUE CHAIN OF THE UPSTREAM PETROLEUM INDUSTRY
Prospect
A prospect is an idea. It is a geologic idea of where technical specialist thinks crude oil and natural gas might
be trapped in a reservoir within the Earths subsurface. The prospect idea is usually created by an
interdisciplinary technical team comprised of a geologist, geophysicist, and engineers who work on a
geographical area of interest. Their job is to identify the opportunity using maps and cross-sections to
calculate the amount of crude and oil and natural gas contained in the reservoir trap, determine the
production rate, and estimate the investment. (The University of Texas at Austin - PETEX, 2011)
Exploration and Appraisal
Explorers of oil and gas traps are called exploration geologist and geophysicist. These professionals search
for subsurface traps that might contain hydrocarbons. They use seismology
3
in their research. Seismic
exploration studies sound wave vibrations as they travel through rock layers.
To exert man-made vibrations, explosives such as dynamite are often used to make a low-frequency sound
powerful enough to penetrate thick layer of rocks. The reflected sound bounces back and recorded. The
information is downloaded into a computer and creates a seismic section, which is a two-dimensional slice
from the surface of the earth downward. This is known as 2D seismic. Expert interpretation of the seismic
sections can reveal if there is a trap where petroleum could exist.
Exploration techniques only indicate where an oil and gas trap might be; in most cases, they do not directly
indicate the presence of hydrocarbons in a trap. The only sure way to find out is to drill a hole down into the
trap and see.
Before a well is drilled, it is appraised to determine the capital to be invested and the future net revenue.
Important elements of the prospect appraisal are, among other factors:
Estimated volume of crude oil and natural gas (reserve)
Estimated ultimate recovery, which is expected units of production
Estimated costs to drill the appraisal well and, if successful, to equip the well for production
Estimated commodity prices for crude oil and natural gas
Future gross and net revenue

Making a decision to invest is the last step in the prospect approval process and the drilling of a new well.
This is the step where management has:

3
Seismology is the study of natural and man-made vibrations in the earth.
Prospect
Exploration
and Appraisal
Development Production Abandonment

pg. 10

Evaluated the technical merit of the prospect
Assigned risk factors to the processes of drilling, completion, reserves, production, and market price
for the commodity to be produced
Evaluated the economic merit of the prospect
Calculated the return on capital to be invested

(The University of Texas at Austin - PETEX, 2011)
Development
Before a petroleum company can develop oil or gas reserves, it must acquire the legal rights to explore, drill,
and produce on the site. Acquiring rights differs from country to country. In most oil producing nations, the
national government owns its mineral resources. Governments worldwide frequently section their lands into
smaller areas and regularly offer licenses or leases to oil companies that permit exploring, developing, and
producing oil and gas located under the land. The terms and conditions of such agreements can vary widely
around the globe. (The University of Texas at Austin - PETEX, 2011)
Once sufficient data has been obtained to make an educated judgment on the size of the prize, we enter into
the development phase. Here we decide on the most commercially viable way for exploiting this new
resource by engineering the number (and type) of producing wells, process facilities, and transportation
(Bailey, 2006). The time-consuming process of developing, engineering, building, and installing the solutions
results in period of high investments and negative cash flows.
Production
A normal production profile involves high production in the beginning of fields lifetime. After a period of time
production starts to decline, and continues to decline. Oil can flow out of a reservoir and up the well to the
surface using the natural stored energy of the fluids, or it might have to be lifted artificially. Two ways to
artificially lift oil and gas are using pumps and injecting gas.
Even with artificial lift, all the oil in a reservoir will not be recovered. Three-fourth of the oil, or more in some
cases, might remain in place unless additional recovery techniques are used. Two ways to recover more oil
are through water-flooding and miscible process. Even these additional recovery techniques will not recover
all the oil in a reservoir.
(The University of Texas at Austin - PETEX, 2011)
Abandonment
Once reserves have been depleted, the infrastructure can either be left to decay or (increasingly) must be
dismantled in an environmentally and economically efficient manner. This is especially true for the North Sea
and offshore United States (Bailey, 2006).
Decision about shutting down and abandonment of the field should be made on the bases of total amount of
extractable reserves left, production rates, oil price levels, costs of liquidation and alternative investment and
resource allocation opportunities. Cost of abandonment should be taken into account and estimated already
at the time of valuation.

pg. 11

Petroleum Economics

If we translated above value chain analysis story (prospect exploration development production
abandonment) into a cash flow, the picture will looks like figure 3. It is a very challenging industry. Significant
cash outflow will dominate for many years, only to get cash inflow far away in the future. One can only
imagine, if, at the time production can finally start, oil price suddenly crash.
The life of oil and gas property is finite. Unlike other project valuation that normally can assume a terminal
value which is all cash flows expected beyond the forecast period, in oil and gas environment the
assumption of perpetuity is not realistic. Instead, the offshore project will face a huge cash outflow at the end
the life cycle, driven by abandonment and retirement obligation costs.
Finally, it is important to point out that fee, taxes, and royalties are so significant. In Norway, for example, the
petroleum tax consists of 28% general income tax, and additional 50% special tax. This creates two
implications. (1) Is the incentive for debt financing, and (2) importance of proper tax management, to
anticipate mismatch between huge loss in early years and huge profits in the later years.

FIGURE 3 A TYPICAL E&P CASH-FLOW PROJECT (SUSLICK, SCHIOZER, & RODRIGUEZ, 2009)

pg. 12

Chapter 3 Stochastic Forecasting
Revenue is the foundation to forecast cash flow. In Upstream Business, Revenue is defined as units of crude
oil and natural gas produced and sold, multiplied by a commodity price. Both volume and price are highly
uncertain and difficult to forecast. In the case study, the base case production forecast is given, and later on
uncertainty surrounding the volume will be accounted by subjective probability distribution in the Decision-
Tree Analysis. In the other hand, oil price will be forecasted using stochastic technique (this chapter). Once
the stochastic process is done, the result will be used as base case price. Later on, uncertainty surrounding
the oil price will be accounted by a Monte Carlo simulation.
Oil Price
Selecting a price today is easy because the market information is current and reliable. Selecting a price 15 to
20 years from today is another issue. Predicting future price is very difficult because so many economic
variables influence it. Oil price is the weakest link in valuation process.
Demand and supply determine the prices and the quantities traded in these commodity markets. The two key
influences on the demand for oil are: (1) The value of marginal product of oil, and (2) The expected future
price of oil. The three key influences on the supply of oil are: (1) The known oil reserves, (2) The scale of
current oil production facilities, and (3) The expected future price of oil.
To remove the uncertainty of future prices, most Upstream Business Units establish a set of crude oil and
natural gas prices for the start of the project and into the future. This set of prices is a baseline and is called a
price deck. Price decks change over time with changes in the cash and future markets, so price decks can be
updated frequently. (The University of Texas at Austin - PETEX, 2011)

FIGURE 4 MONTHLY AVERAGE CRUDE OIL PRICE JAN 1975 TO JUN 2012

pg. 13

Stochastic Process
A stochastic process is nothing but a mathematically defined equation that can create a series of outcomes
overtime, outcomes that are not deterministic in nature. A stochastic process is by definition nondeterministic,
and one can plug numbers into a stochastic process equation and obtain different results every time. For
instance, the path of oil price is stochastic in nature, and one cannot reliably predict the exact oil price path
with any certainty. However, the price evolution over time is enveloped in a process that generates these
prices. The process is fixed and predetermined, but the outcomes are not. (Mun J. , Modeling Risk, 2010)
Brownian-Motion
A Wiener process, also called a Brownian motion, is a continuous-time stochastic process with three
important properties. First, it is a Markov process, which means that the probability distribution for all future
values of the process depends only on its current value, and is unaffected by past values of the process or by
any other current information. As a result, the current value of the process is all one needs to make a best
forecast of its future value. Second, the Wiener process has independent increments. This means that the
probability distribution for the change in the process over any time interval is independent of any other (non-
overlapping) time interval. Third, changes in the process over any finite interval of time are normally
distributed, with a variance that the increases linearly with the time interval.
The Markov property is particularly important. Again, it implies that only current information is useful for
forecasting the future path of the process. Stock prices are often modelled as Markov processes, on the
grounds that public information is quickly incorporated in the current price of the stock, so that the past
pattern of prices has no forecasting value. (This is called the weak form of market efficiency. If it did not hold,
investors could in principle beat the market through technical analysis, that is, by using the past pattern of
prices to forecast the future).The fact that a Wiener process has independent increments means that we can
think of it as a continuous-time version of a random walk.
The three conditions discussed above: the Markov property, independent increments, and changes that are
normally distributed; may seem quite restrictive, and might suggest that there are very few real-worlds
variables that can be realistically modelled with Wiener processes. Through the use of suitable
transformations, the Wiener process can be used as building block to model an extremely board range of
variables that vary continuously and stochastically through time.
(Avinash K. Dixit, 1994)
Risk Simulator
4
software will be used to model future oil price in this thesis. For stochastic process:
Brownian motion (Random Walk) with Drift, the following inputs is needed:
Stochastic Process: Brownian Motion (Random Walk) with drift
Start Value ($) ... Steps ...
Drift Rate ... Iterations ...
Volatility ... Reversion Rate Not applicable
Horizon (Years) ... Long-Term Value Not applicable

TABLE 2 DATA INPUT NEEDED FOR BROWNIAN MOTION

4
http://risksimulator.com/

pg. 14

Mean-Reverting Price Model
Most of the real options literature assumes the underlying uncertainty (in this case, oil prices) follows a
random walk, specifically geometric Brownian motion. In this model, oil prices at any future time are
lognormal distributed with the conditional distribution for later price shifting by the amount of any
(unexpected) change in prices in the early years.
One might argue that, when prices are high compared to some long-run average (or equilibrium price level),
new production capacity comes on line, that older properties expected to come off line stays on line, and
prices tend to be driven back down toward this long-run average. Conversely, if prices are lower than this
long-run average, less new production comes on line, older properties are shut down earlier, and prices tend
to be driven back up. Thus oil prices should be mean reverting in that prices tend to revert to some long-run
average (James E. Smith, 1999).
Thus one might argue that the price of oil should be modelled as a mean-reverting process. The simplest
mean-reverting process, also known as an Ornstein-Uhlenbeck process, is the following
(1) () ( )

Here, is the speed of reversion, and is the normal level of , that is, the level to which tends to revert.
(If is an oil price, then might be the long-run marginal cost of production of crude oil). describes the
volatility of the process, and represents increments of a standard Brownian motion process.
If the value of is currently and follow equation (1), then its expected value at any future time is
(2) [] ( )

Also, the variance of ( )is
(3) [ ]
)

Observe from these equations that the expected value of converges to as becomes large, and the
variance converges to
. Also as , [] , which means that can never deviate from , even

momentarily.
(Avinash K. Dixit, 1994)
Risk Simulator software will be used to model future oil price in this thesis. For stochastic process: Mean-
Reversion Process with Drift, the following inputs is needed:
Stochastic Process: Mean-Reversion Process with Drift
Start Value ($) ... Steps ...
Drift Rate ... Iterations ...
Volatility ... Reversion Rate ...
Horizon (Years) ... Long-Term Value ...

TABLE 3 DATA INPUT NEEDED FOR MEAN-REVERSION

pg. 15

Chapter 4 Valuation of Oil and Gas Properties
The valuation of oil and gas properties is directly related to the ultimate value of petroleum resources that
may be extracted in the future. Due to various geological and economic risks, oil and gas properties present
unusual complexities in applying traditional valuation techniques.
Income (DCF) Approach
For valuing proved oil and gas properties, the income approach is, by far, the most common method used in
practice. The income approach is most appropriate when detailed reserve reports are available to project the
future cash flows based on the lives of the reserves.
The income approach values a business or asset on the basis of future cash flows expected to be produced
by the property. The most common income approach is the use of a discounted cash flow method (DCF). In
this method, the present value of expected future net cash flows is discounted using an appropriate discount
rate. (1) The forecasted cash flows, and (2) discount rate are important factors, and each requires the
consideration of numerous facts, assumptions, and judgment.
(Brady, Chang, Jennings, & Shappard, 2011)
Forecast
Production volumes are the foundation for a forecast. They are accessed from a companys internal reserves
estimates, internal economic runs for particular fields or areas, or reserve reports prepared by independent
petroleum engineers. Using basic production volume data, a typical oil and gas cash flow forecast is
developed using assumptions for expected oil and gas prices; production, operating, and development costs;
production taxes; general and administrative expenses; income taxes; and capital expenditures necessary to
produce the oil and gas reserves.
Since the life of an oil and gas property is finite, a cash flow forecast should run for the entire life of the asset
being valued. Traditional DCF techniques outside of the oil and gas industry usually call for a finite forecast
period with a terminal value assumption in the final forecast year that captures all cash flows expected to
extend beyond the forecast period. In an oil and gas environment, the assumption of perpetuity is not
realistic. Terminal value is often a large cash outflow driven by the cost to plug and abandon wells or other
retirement obligations. Assumptions can be made as to the salvage value of materials and equipment.
Discount Rate
A dollar received or paid in the future is worth less than a dollar received or paid today due to the time value
of money. In order to determine todays value of a dollar that will not be received until some point in the
future, it should be discounted to the current period. To accomplish this, an appropriate discount rate must be
selected. The discount rate, also called the weighted average cost of capital (WACC), is the rate of return
that a business, asset, or project must earn for a provider of capital (either debt, equity, or both) to invest.

pg. 16

Practical Issues
Traditional methods assume that the investment is an all-or-nothing strategy and do not account for
managerial flexibility that exists such that management can alter the course of an investment over time when
certain aspect of the projects uncertainty become known.
There are several potential problem areas in using a traditional discounted cash flow calculation on strategic
optionality. These problems include undervaluing an asset that currently produces little or no cash flow, the
non-constant nature of the weighted average cost of capital discount rate through time, the estimation of an
assets economic life, forecast errors in creating the future cash flows, and insufficient tests for plausibility of
the final results. (Mun J. , Real Options Analysis, 2006)
Discounted Cash Flow Advantages
Clear, consistent decision criteria for all projects
Same results regardless of risk preferences of investors
Quantitative, decent level of precision, and economically rational
Not as vulnerable to accounting conventions (depreciation, inventory valuation, and so forth)
Factors in the time value of money and risk structures
Relatively simple, widely taught, and widely accepted
Simple to explain to Management
Discounted Cash Flow Disadvantages

DCF Assumptions Realities
Decisions are made now, and cash flow
streams are fixed for the future.
Uncertainty and variability in future outcomes. Some decisions
deferred to the future, when uncertainty resolved.

Once launched, all projects are passively
managed.
Projects are usually actively managed through checkpoints,
decision options, budget constraints, and so forth.

Future free cash flow streams are highly
predictable and deterministic.
It may be difficult to estimate future cash flows as they are
usually stochastic and risky in nature.

Discount rate used in the opportunity cost
of capital, which is proportional to non-
diversifiable risk; All risks are completely
accounted for by the discount rate.
There are multiple sources of business risks with different
characteristics, and some are diversifiable across projects or
time; Firm and project risk can change during the course of a
project.

All factors that could affect the outcome of
the project and value to the investors are
reflected in the DCF model through the
NPV or IRR.
Because of project complexity and so-called externalities, it may
be difficult or impossible to quantify all factors in terms of
incremental cash flow. Distributed, unplanned outcomes can be
significant and strategically important.

Unknown, intangible, or immeasurable
factors are valued at zero
Many of the important benefits are intangible assets or
qualitative strategic positions

TABLE 4 DCF DISADVANTAGES (MUN J. , REAL OPTIONS ANALYSIS, 2006)

pg. 17

Financial Modelling
Discounted Cash Flow (DCF) seems relatively simple. However, to accurately forecast the free-cash-flow-to-
the-firm, a proper financial model is needed. This means a forecasted income statement, balance sheet, and
cash flow. An example of why this is important is tax loss carry forward. Due to offshore project nature, there
is a mismatch between huge loss in early years and huge profits in the later years. It is not correct to assume
that tax loss will be refunded in the same year (because its not). It needs to be accumulated over time as tax
asset and once the project start generating profit, it can be utilized to reduce tax liabilities. Having a decent
and interlinked financial model is a pre-requisite for meaningful DCF valuation, Monte Carlo simulation,
Decision Tree analysis, and Real- Options.
Balance sheet
The balance sheet gives a snapshot of the company assets and liabilities at an instant time, e.g. 12 oclock
midnight on 31 December 2013. Further snapshots will be taken at fixed intervals. After each interval the
sums recorded against the various components of the balance sheet will have changed. An analysis of these
changes gives crucial information about the companys activities over the period in question. (Walsh, 2008)
Profit and loss account
The profit and loss account quantifies and explains the gains or losses of the company over the period of
time bounded by the two (opening and closing) balance sheets. It derives some values from both balance
sheets. Therefore it is not independent of them. It is not possible to alter a value in the profit and loss account
without some corresponding adjustment to the balance sheet. In this way the profit and loss account and
balance sheet support one another. (Walsh, 2008)
Cash flow
The cash flow statement depends on the two (opening and closing) balance sheets and the profit and loss
account. It links together the significant elements of all three. The numbers on the cash flow statement are
objective: cash is cash, and the amounts of cash flows are not influenced by the judgments and estimates
that are made in arriving at revenues, expenses, and other accruals. (Anthony, Hawkins, & Merchant, 2011)
Free cash flow to the firm
Free Cash Flow to the Firm (FCFF). This is the cash available to bond holders and stock holders after all
expense and investments have taken place. It is defined as: EBIT * (1 - tax rate) - (Capital Expenditures -
Depreciation) - Change in Working Capital. Net Present Value (NPV) can be calculated from FCFF.
Later in the case study, the Author will also calculate the Adjusted Present Value (APV).
The idea behind adjusted present value (APV) is to divide and conquer. APV does not attempt to capture
taxes or other effects of financing in a WACC or adjusted discount rate. A series of present value calculation
is made instead. The first establish a base-case value for the project or firm: its value as a separate, all-
equity-financed venture. The discount rate for the base-case value is just the opportunity cost of capital.
Once the base-case value is set, then each financing side effect is traced out, and the present value of its
cost or benefit to the firm is calculated. Finally, all the present value are added together to estimate the
projects total contribution to the value of the firm.

pg. 18

Chapter 5 Monte Carlo Simulation

FIGURE 5 MONTE CARLO, @ RISK

Monte Carlo simulation, named for the famous gambling capital of Monaco, is a very potent methodology.
For practitioner, simulation opens door for solving difficult and complex but with great ease. Simplistically,
Monte Carlo simulation creates artificial futures by generating thousands of sample paths of outcomes and
analyzes their prevalent characteristics. An alternative to simulation is the use of highly complex stochastic
closed-form mathematical models. In all cases, when modeled correctly, Monte Carlo simulation provides
similar answers to the more mathematically elegant methods. (Mun J. , Modeling Risk, 2010)
A Monte Carlo simulation is undertaken by modeling a project and its key factors affecting the profitability of
the project. A computer with proper software is asked to simulate all possible outcomes for the project. The
simulation should be done as many times as possible. By analyzing the results it is possible to plot a
frequency distribution of the outcomes and to calculate expected values, upper limits and lower limits.
The process can be divided into four steps. Step (1) is to model the project. The computer needs a precise
model of the project, including revenue and cost equations and the interdependence between different
periods and different variables. Step (2) involves specifying probabilities for estimation errors. The estimation
of different key factors should be given with corresponding optimistic and pessimistic estimates. This should
enable you to specify probabilities for estimation errors. Step number (3) involves simulation of cash flows.
The computer samples from the distribution of the forecast errors, calculates the resulting cash flows for each
period, and records them. After many simulations, accurate estimates of probability distributions of project
cash flows will occur. The last step (4) involves calculating NPVs. The distributions of the project cash flows
should enable decision makers to calculate expected cash flows more accurately.
Drawbacks of the Monte Carlo simulation include time and resources in building an accurate model of the
project. It is difficult to estimate correlation between variables and underlying probability distributions. If the
model and the underlying variables are wrong, the results of the simulations will be wrong. The simulation will
only be as good as the estimates and the correctness of the model.
(Brealey, Myers, & Allen, 2011)

pg. 19

Sensitivity Analysis
Usually, a sensitivity analysis is first performed on the discounted cash flow model. Armed with this
information, the analyst can then decide which key variables are highly uncertain in the future and which are
deterministic. The uncertain key variables that drive the net present value are prime candidate for Monte
Carlo simulation.
Capturing the essence of a problem by determining influential factors helps decision-makers concentrate on
only those issues that play a major role in the outcome. For example, one decision may depend on six
factors: (1) oil price, (2) oil volume, (3) gas price, (4) gas volume, (5) capital expenditure, and (6) operating
costs but the relative importance of these is unknown. For given uncertainties, or a range of possible
values, for each factor, sensitivity analysis calculates the net present values represented by those
uncertainties and rank each factor, like a tornado (see Figure 6).

FIGURE 6 EXAMPLE OF TORNADO PLOT OIL AND GAS PROJECT (COOPERSMITH, DEAN, MCVEAN, & STORAUNE, 2001)

The author want highlight type of risk represented by the above tornado plot, please keep below information
in mind while we are progressing with decision tree and real-options.

Factors
Risks
Comments Private Market
Oil price Risk-neutral probabilities
Oil volume Subjective probabilities
Capital expenditures Somewhere in between
Gas volume Subjective probabilities
Gas price Risk-neutral probabilities
Operating costs Somewhere in between

TABLE 5 IMPORTANT FACTORS IN OIL AND GAS PROJECT WITH THEIR RISK PROFILE

pg. 20

Chapter 6 Decision Tree
Decision-tree analysis is one way to frame and solve complex situations that require a decision. The key to
obtaining a useful solution is to clearly define the problem at the start and determine what decisions need to
be made. The problem-definition stage includes identifying all known information and listing any factors that
may influence the final outcome. To expedite the process, decisions that can be deferred are postponed so
that future information can aid the decision process.
Once the problem is framed, decisions trees help find a route to an advantageous solution. Decision trees
are diagrams that portray the flow of a decision-making process as a sequence of events and possible
outcomes. Events are represented as points, or nodes, and outcomes are depicted as branches issuing from
each node. Nodes are either decision nodes, at which the decision-maker determines what branch to take, or
uncertainty nodes, where chance rules the outcome. Additionally, branches emanating from uncertainty
notes are weighted by the probability of that outcome occurring. In common notation, decision nodes plot as
squares and uncertainty nodes as circles. (See figure 7 for example)
(Coopersmith, Dean, McVean, & Storaune, 2001)

FIGURE 7 EXAMPLE OF DECISION TREE (COOPERSMITH, DEAN, MCVEAN, & STORAUNE, 2001)

In contrast to Monte Carlo simulations which evaluate pre-determined project scenarios, decision trees focus
on managerial decisions. They also take account of uncertainty on important parameters, but they do so in a
more rudimentary way, typically, by specifying the probabilities that the reserves fall into broad classes such
as large, small or zero. In decision tree, at circular (uncertainty) nodes the expected value is calculated;
then at decision nodes the most favorable branch is chosen. So from a mathematical point of view, a
decision tree is a way of evaluating maximum expected NPV. (A.Galli & Armstrong, 1999)

pg. 21

Options
Decision analysts in Oil and Gas have long modeled options/ choices using decision tree model. If we
summarized them based on value chain analysis story (prospect exploration development
production abandonment), it can be briefly described as follows:
Phases Description Decision Maker Choices

Prospect,
Exploration
and Appraisal

Seismic data is obtained and a
picture of the subsurface is then
revealed. Seismic data cannot tell
what fluids are present in the rock,
so an exploratory well needs to be
drilled, and from this, one is then
able to better establish the nature,
size, and type of an oil and gas
field.

The decision maker has numerous options available to him/ her,
which may include:

Extent of investment needed in acquiring seismic data.
Should one invest in 3D seismic studies that provide greater
resolution but are significantly more expensive?

Given inherent uncertainty about the reserves, if possible,
how much should the company share in the risk?

How many exploration wells are appropriate to properly
delineate the field? One, two, five, or more?

Development

Once sufficient data has been
obtained to make an educated
judgment on the size of the prize,
we enter into the development
phase. Here we decide on the
most commercially viable way for
exploiting this new resource by
engineering the number (and
type) of producing wells, process
facilities, and transportation.

This phase is where decision makers face possibly the greatest
number of valid alternatives. Valid development options include:

How many wells should be drilled? Where should they
locate? In what order should they drill?

Should producers be complex (deviated/ horizontal) wells
located at the platform, or should they be simple but tied-
back to a subsea manifold?

How many platforms or rigs will be needed? If offshore,
should they be floating or permanent?

What potential future intervention should be
accommodated? Intervention refers to an ability to reenter a
well to perform either routine maintenance or perform major
changes (referred to as a work-over).

How many injectors should be drilled? Where?

How large should the processing facility be? If small, the
capital expenditure will be reduced but may ultimately limit
throughput. If it is too large, operationally inefficient.

Are there adjacent fields waiting to be developed? If so,
should the process facility be shared?

Should a new pipeline be laid? If so, where would it be best
to land it, or is it possible to tie it into and existing pipeline
elsewhere with available capacity? Should other
transportation methods be considered (e.g. FPSO, or
floating production and storage operation)

(Bailey, 2006)

pg. 22

Phases Description Where Real Options Come In

Production

Depending on the size of the
reserve (and how prolific the wells
are) the engineer must manage
this resource as carefully as any
other valuable asset. Reservoir
management (the manner and
strategy in which we produce from
a field) has become increasingly
important. Older, less technically
advanced, production methods
were inefficient, often leaving 75
percent or more of the oil in the
ground oil that cannot be easily
extracted afterward, if at all.
Increasing the efficiency of
production from the reservoirs is
now crucial part of any
engineering effort.

Valid production options include:

Are there any areas of the field that are unswept and can be
exploited by drilling more wells?

Should we farm out (divest) some, or all, of the asset to
other companies?

Should we consider further seismic data acquisition?

Should we consider taking existing production wells and
converting them into injection wells to improve the overall
field performance?

What options does one have to extend the life of the field?

Should we consider reentering certain wells and performing
various actions to improve their performance (e.g.,
perforating some or the entire well, shutting off poorly
producing zones, drilling a smaller branch well [known as
sidetrack] to access unswept reserves, etc.)? What
information needs to be collected to be able to make these
operational decisions? How such information is best
obtained? At what cost and at what operational risk?

Abandonment

Once reserves have been
depleted, the infrastructure can
either be left to decay or
(increasingly) must be dismantled
in an environmentally and
economically efficient manner.
This is especially true for the
North Sea and offshore United
States

Valid abandonment options include:

What will the ultimate abandonment cost be, and what is the
likelihood that this will remain true at the end of the life of
the field?

Should the full cost of abandonment be included in the initial
development strategy, or is there a way to hedge some or
all of this cost?

What contingency should be built in to account for changes
in legislation?

At what threshold does abandonment cost make the project
unprofitable, and how would this impact our initial
development strategy.

TABLE 6 OPTIONS/ CHOICES SUMMARIZED FROM (BAILEY, 2006)

To perform Monte Carlo Simulation and Decision Tree Analysis, this thesis will use software @Risk and
Precision Tree from Palisade
5

5
http://www.palisade.com/

pg. 23

Chapter 7 Valuing Flexibility, Real-Options
In valuing companies with the standard discounted cash flow approaches, we did not consider the value of
managerial flexibility. Managers react to changes in the economic environment by adjusting their plans and
strategies. For example, they may choose to scale back or abandon an investment project that delivers poor
results, or to expand or extend the project if it is highly successful. Such flexible changes of plan can take
many different forms, and each may have substantial impact on value. A standard DCF approach based on a
single cash flow, or even multiple cash flow scenarios, cannot calculate what that impact is.
Managerial flexibility is not the same as uncertainty. Companies or projects with highly uncertain futures
involving a single management decision, such as offshore project, they may decide whether to proceed or
not at each stage, depending on information arising from the stage before. For cases where managers
expect to respond flexibly to events, we need a special, contingent valuation approach.
Flexibility is typically more relevant in the valuation of individual businesses and projects, as it mostly
concerns detailed decisions related to production, capacity investments, marketing, research and
development, and so on. In this thesis, we concentrate on how to value flexibility when valuing projects.
We explore two contingent valuation approaches: (1) Real-Option Valuation (ROV) based on formal option
pricing models, and (2) Decision Tree Analysis (DTA). Although they differ on some technical points, both
boil down to forecasting, implicitly or explicitly, the future free cash flow contingent on the future states of the
world and management decisions, and then discounting these to todays value.
Room for
managerial
flexibility
High
Moderate
flexibility value

High
flexibility value

Low
Low
flexibility value

Moderate
flexibility value

Low High
Likelihood of receiving new information
FIGURE 8 WHEN IS FLEXIBILITY VALUABLE?

The value of flexibility is related to the degree of uncertainty and the room for managerial reaction. It is
greatest when uncertainty is high and managers can react to new information. In contrast, if there is little
uncertainty, managers are unlikely to receive new information that would alter future decisions, so flexibility
has little value. In addition, if managers cannot act on new information that becomes available, the value of
flexibility is also low. See figure 8.
(McKinsey & Company, 2010)

pg. 24

Real-Options
Contingent valuation is an important tool for helping managers makes the right decisions to maximize
shareholder value when faced with strategic or operating flexibility. However, in real life, the flexibility is never
as well defined and straightforward. A lot depends on managements ability to recognize, structure, and
manage opportunities to create value from operating and strategic flexibility.
To recognize opportunities for creating value from flexibility when assessing investment projects or
strategies, managers should try to be as explicit as possible about the (1) Events: what are the key sources
of uncertainty, (2) Decisions: What decisions can management make in response to events?, and (3)
Payoffs: What payoffs are linked to these decisions.
Abandonment Option: An abandonment option provides the holder the right but not the obligation to
sell off and abandon some project, asset, or property at a specified price and term.

Barrier Option: A barrier means that the option becomes live and available for execution and
consequently the value of the strategic option depends on either breaching or not breaching the artificial
barrier.

Expansion Option: An expansion option provides management the right and ability to expand into
different markets, products, and strategies or to expand its current operations under the right conditions.

Chooser Option: A chooser option implies that management has the flexibility to choose among several
strategies, including the option to expand, abandon, switch, contract, and combinations of other exotic
options.

Contraction Option: A contraction option provides management the right and ability to contract its
operations under the right conditions, thereby saving on expenses

Deferment Option: This type of option is also a purchase option or an option to wait.

Sequential Compound Option: A sequential compound option means that the execution and value of
future strategic options depend on previous options in sequence of execution.

Switching Option: A switching option provides the right and ability but not the obligation to switch
among different sets of business operating conditions, including different technologies, markets, or
products.

(Mun J. , Modeling Risk, 2010)

pg. 25

Methods for Valuing Flexibility
Real-Option Valuation (ROV)
Option-pricing models use a replicating portfolio to value the project. The basic idea of a replicating portfolio
is straightforward: if you can construct a portfolio of priced securities that has the same payouts as an option,
the portfolio and the option should have the same price. If the securities and the option are traded in an open
market, this identity is required; otherwise arbitrage profits are possible.
Contingent NPV can also be determined with an alternative ROV approach called risk-neutral valuation. The
name is somewhat misleading because a risk-neutral valuation does adjust for risk, but as part of the
scenario probabilities rather than the discount rate. To value an option, weight the future cash flows by risk-
adjusted (or so-called risk neutral) probabilities instead of actual scenario probabilities. The probability-
weighted average cash flow is then discounted by the risk-free rate to determine current value.
Decision Tree Analysis (DTA)
A second method for valuing a project with flexibility is to use decision tree analysis (DTA). This leads to the
right answer in principle, but only if we apply the correct cost of capital for a projects contingent cash flow.
One DTA approach is to discount the projects contingent payoffs net of the investment requirements. A
better DTA approach separately discounts the two components of the contingent cash flows. The contingent
payoffs are discounted at the cost of capital. The investment is discounted at the risk-free rate.
Underlying risk: Diversifiable versus Non-Diversifiable
Investment projects can be exposed to a wide range of risks. The question is which particular risk (or group
of risk) could affect a projects cash flow that it would change managements future decisions. If commodity
prices, as in mining, the oil industry, or power generation, are keys to future investment decisions, the key
underlying risk is non-diversifiable. Other examples include interest or currency risks or risks that are strongly
correlated with overall economic activity. If geological risks such as the size of undeveloped oil field are
crucial, the underlying risk is diversifiable because the correlation with overall economic activity is low.
When non-diversifiable risk is driving future investment decisions, only ROV leads to theoretically correct
valuation. The DTA approach might end up close but is difficult to apply because it is unclear how to discount
the projects contingent cash flows. For diversifiable underlying risk, a straightforward DTA is an effective tool
for valuing flexibility. In this case, we can discount the projects payoffs in each scenario at the cost of capital
of the underlying asset and discount the investment requirements at the risk-free rate.
(McKinsey & Company, 2010)

Available Data
Non
traded
assets

Decision
tree analysis
Decision tree
analysis, Real-Option
Valuation

Traded
assets

Decision
tree analysis
Real-Option
Valuation

Diversifiable Non-diversifiable
Underlying risk
FIGURE 9 APPLICATION OPPORTUNITIES FOR ROV VERSUS DTA (MCKINSEY & COMPANY, 2010)

pg. 26

The Integrated Approach
There is a concern that the models described in the real options literature greatly oversimplify the problems
they actually face. For example, an undeveloped oil property is superficially analogous to a call option on a
stock, but in reality there are many complications (uncertain production rates, development costs,
construction lags, complex royalty and tax structures, the lack of true underlying stock, etc.) that strain the
analogy. Moreover, most of the articles describing the benefits of the options approach based on point
estimates of all cash flows. It was not clear what advantages the options approach would have compared to
decision analysis approach. (James E. Smith, 1999)
The integrated approach begins by noting that there are two types of risk associated with most corporate
investments: public (non-diversifiable) and private (diversifiable). The integrated approach acknowledges that
most investment problems have both kind of risk and it is designed to address that very situation.
This approach was first described in depth in 1995 article by James Smith and Robert Nau and in a 1998
article by Smith and Kevin McCardle. Both articles refer specifically to their approach as the integration of
option pricing and decision analysis, not as real options analysis approach per se.
According to Smith and McCardle, the basic idea of integrated valuation procedure is to use option pricing
methods to value risks that can be hedged by trading existing securities and decision analysis procedures to
value risks that cannot be hedged by trading.
To implement this approach, Smith and Nau use what may be termed a risk-adjusted decision tree, in which
public and private risks are identified explicitly, opportunities for hedging public risks are assumed available,
and opportunities for arbitrage are removed.
The integrated approach involves the following steps:
1. Build a decision tree representing the investment alternatives
2. Identify each risk as either public or private
3. For private risks, assign subjective probabilities
4. Apply a spreadsheet cash-flow model at each tree end point, an calculate NPV using the risk-free rate
5. Roll back the tree to determine the optimal strategy and its associated value
6. Perform Monte Carlo simulation for public risks in the decision tree; the result will be different sets of
optimal strategy for different circumstances, and a distribution of real options valuation.
The integrated approach appears to be the only one that takes the view that corporate investments typically
involve a mix of public and private risks, and that an accurate valuation depends on addressing both. It
presents an approach that covers the range of corporate investments as a continuum from traditional
decision analysis at one extreme (all private risks) to finance theory or option pricing at the other (all public
risks). Perhaps because this approach stands so squarely between the separate camps of finance theory
and decision theory, it seems to be remarkably unfamiliar to both the finance and management science
academic communities.
(Borison, 2005)

pg. 27

Chapter 8 Case Study
6
Kukuza Offshore Oilfield
Introduction
By end of June 2012, Kukuza (the Company) had spent nearly 4 years exploring the Alpha field in North
Sea. In-place resource is estimated at 35 million sm
3
oil. The Ministry of Petroleum and Energy just
announces an invitation to apply for petroleum production licenses on the Norwegian Continental Shelf. The
application must be submitted by 4th December 2012 at 12:00 hours. Eddie (the CEO) set a kick-off meeting
to prepare production license application. Ben, recently hired as Project Finance Manager, will be
responsible for the overall project economics. Important points are:
Commodity price estimates: The Norwegian Petroleum Directorate (NPD) suggested price assumption
to be set at $ 69/ barrel. Andy (the CFO) looked at his Bloomberg terminal and saw that closing price of
Brent Crude Oil in June was $ 90/ barrel. The CFO advises Ben to forecast the oil price by himself.

Cost of capital: The NPD suggested cost of capital 7%. It seems too low for Kukuza Offshore Oilfield.
Again, the CFO asked Ben to forecast the cost of capital by himself.

Incentives for debt financing/ tax shields: Financial charges are tax deductible. This creates major
incentives for debt financing since the petroleum tax is in Norway very high. Eddy decided that the
funding structure will be 70/30 debt to equity. Radha (the Treasury) informed Ben that the borrowing cost
is 3-month NIBOR plus 6.75 percent.

Option to expand: Sean (the COO) explains that there is a possibility to expand into 2 smaller fields
(Bravo and Charlie). In-place resource for oil in Bravo and Charlie field is estimated at 4 million sm
3
+ 1.0
billion Sm
3
gas and 3.0 sm
3
million + 0.6 billion Sm
3
gas respectively.

Development plan: Sean explains sequence of events with possible outcomes. There are still
uncertainties in the size and recovery factor of the reservoir. The final decision whether to expand, to
continue, or to abandon can only be made in 2016, after obtaining pre-drilling results of 5 initial wells.
Ben is now in his office. He starts reading the base case scenario development plan
7
for the three fields.
The document has the following information: (1) Prospect, (2) Exploration and Appraisal, (3) Development,
(4) Production, (5) Abandonment, and (6) Economics.
As this is the first big project for the Company, Ben knows that it is crucial to get an accurate picture of the
valuation on this field. Unfortunately, he is not sure how to account diversifiable risk (i.e. reservoir size), non-
diversifiable risk (i.e. oil price), and managements flexibility (i.e. to expand) into his valuation.

6
This case is based on generalized experience, with a fictional story and characters, but the salient features resemble
the development of Aasen field in the North Sea by Det norske oljeselskap ASA. Technical and Commercial data is
based on published source: The Norwegian oil company ASA, The plan for development and operation of Ivar Aasen
field, Part 2: Impact assessment, September 2012 and assumptions made by the Author (arivai@mba14.rsm.nl)

7
In real-world upstream petroleum economic models, field assumptions are the combined product of the efforts of
earth scientists and petroleum engineers. Each of their disciplines is beyond the scope of this thesis, which focuses on
how real options can be applied to valuation and decision making. Therefore, we will use raw technical data, with no
attempt to make them any more detailed than needed to make our valuation and decision making points.

pg. 28

Prospect Exploration Development Production Abandonment
Prospect

FIGURE 10 LOCATION OF FIELD ALPHA, BRAVO, AND CHARLIE

Field ABC is situated in the northern part of the North Sea at water depth of about 110-112m (See figure 10).
The development of the field comprises of three discoveries, namely (1) Alpha, (2) Bravo, and (3) Charlie.
The production period as the basis for the valuation is from fourth quarter of 2016 to the end of 2028. Drilling
starts in 2015 and will initially run for three years. The three fields are estimated to hold reserves of about
150 million barrels of oil equivalent (boe) with anticipated economic life up to 20 years.
Alpha is planned as a coordinated development of Delta field located 10 km southeast. On Alpha field, the
Company will build a fixed platform on steel foundation (jacket) with plants for one-step (partial) processing.
The platform will also have living quarters. The wells are drilled with a separate jack-up rig. A jackups drilling
rig will be placed on Alpha platform for the first 3-4 years. Later it will be necessary to place a modular drilling
unit on facility for work overs and interventions.
On Bravo field, the Company will build a subsea installation tied to platform Alpha with a 14 km pipelines. Oil
and gas will be transported to Delta field 10 km southeast, for further processing and export markets. Oil will
be exported via Grane to Sture terminal and Gas will be exported via SAGE to St. Fergus.

pg. 29

Exploration and Appraisal

FIGURE 11 STRUCTURES AND RESERVOIR FORMATIONS

Alpha
Alpha discovered in 2008 with well 16/1-9. Distance to the Norwegian coast is about 160km. Alpha discovery
is mapped based on several seismic surveys and the drilling of wells. Data collection has been extensive,
including a full well test (DST) to verify production characteristics. The reservoir quality is good to moderate.
In-place resource is estimated at approx. 35 million Sm
3
oil and 9.1 billion Sm
3
gas.
Bravo
Bravo discovered in 1997 with well 25/10-8. The discovery consists of two thin sands, upper gas-filled sand
and lower oil-field sand. The discovery is located 12km north-east Alpha. Bravo is mapped based on a well
with a sidetrack. A full scale drill stem test (DST) was conducted in the lower oil sand and proved excellent
permeability. However, the reservoirs were invisible on the seismic data. Conservative assessment of in-
place resource in Bravo is approx. 4 million Sm
3
3
gas.
Charlie
Charlie drilled in 2004, with well 16/1-7, and discovered oil in Middle Jurassic sands. Charlie is mapped
based on several seismic surveys and the drilling of one well. The discovery is located 3 km west of Alpha.
Resources are estimated to be 3 million Sm
3
3
gas.

pg. 30

Development
Drilling rig
The drilling rig CJ-70 Ultra Harsh jackups rig is used to drill wells on Alpha and Charlie (See figure 12). The
rig (owned by Maersk Drilling) is under construction at Keppel FELS shipyard in Singapore and will be
completed in early 2015. Bravo field will be drilled by either jackups rig or floating unit.

FIGURE 12 JACKUPS DRILLING RIG (CJ-70) TO BE USED ON ALPHA

Drilling schedule
15 wells (8 production wells and 7 water injection wells) will be built in Alpha field. Pre-drilling of 3 production
wells and 2 water injection wells is scheduled to start in Q3 2015. The remaining wells will be drilled when the
platform in installed in Q4 2016. Total duration of drilling campaign is about 3 years.
Drilling at Alpha will happen from jackups rig stuck on the seabed. The wells at Alpha/ Charlie will be directly
linked to the platform, while the 2 wells at Bravo will be subsea and connected to platform with an
approximately 14 km production pipeline.

Coordinated development of Alpha and Delta
On March 2012 an agreement was signed between Alpha and Delta field for a coordinated development of
the two fields. Alpha is developed using a fixed platform with one-step (partial) processing and living
quarters. The well stream is separated in an inlet separator, and oil and gas will be transferred from Alpha
platform to Delta platform via pipelines for final processing and export markets. Alpha will be supplied with
electric power from Delta. On Alpha only diesel engines will be installed for emergency generator. Concept is
shown in figure 13.

pg. 31


FIGURE 13 COORDINATED DEVELOPMENT OF FIELD ALPHA AND DELTA

Platform
The development concept consists of a manned platform (Figure 14) located centrally over Alpha reservoir,
and a subsea on Bravo linked against Alpha platform via flow line.
Charlie reservoir drilled from Alpha platform. On platform, produced water is separated and injected with sea
water for pressure support in Alpha and Bravo reservoirs. Sulfate in seawater is removed prior to injection to
prevent the deposition of barium salts in wells, production equipment.
Oil and gas are separated in a one-step process before transmitted via two pipelines to Delta platform for
final processing and export. Initial transfer uses both pipelines, but as the production decreases, only one
pipeline is used to ensure adequate flow rate to reach the specified temperature on arrival at Delta platform.

FIGURE 14 PLATFORM

pg. 32


Subsea installations at Bravo
The installation of Bravo will be a production facility for four wells, and will include wellhead, Christmas trees and
control system (Figure 15). In the first phase, the plant will be completed with equipment for one production well
and one water injection well. The facility will be managed by Alpha platform via an open system with water-based
hydraulic fluids which will only consist of environmentally acceptable components.

FIGURE 15 TYPICAL SUBSEA INSTALLATION

Schedule of the project

2012 Submit Plan for Development and Operation (PDO)

2013 Start building steel jacket for the platform by SAIPEM in Sardinia

2014 Start building the Topside: (1) Main support module, Process module, and Flare Boom by SMOE in
Singapore, (2) Living quarters by APPLY LEIRVIK in Norway

2015 Steel jacket will be put in place by a large crane vessel
After steel jacket is put in place, EMAS will lay pipelines from Alpha to Delta
Then, a jackups rig from MAERSK arrive and start the drilling campaign
Pre-drilling of 5 wells

2016 Installation of Topsides main modules
After that a power cable will be laid from Delta to Alpha
During that same period, a floating hotel will be transported to the field for accommodation during the tie-
in and completion phase
The power cable and pipelines will be tied in
By end of 2016, everything will be ready to start production: partly processed oil and gas will be
transported to Delta Field for further process and export markets

2017 Drilling rig from Maersk will return to install the remaining wells
The work of subsea installation of Bravo will also begin in this period

TABLE 7 PROJECT SCHEDULE

pg. 33

Production

Field Alpha reserves and production plans
Field A is assumed to hold 35.0 million standard cubic meter (Sm
3
) oil and 9.1 billion Sm
3
gas. Note that a
well will not produce all of the oil and gas stored in the pore spaces of the reservoir. Estimated recovery
factor is around 41 percent. So, the commercially recoverable resources are estimated at 13.9 million Sm
3
oil
and 4.3 billion Sm
3
of natural gas. This is approximately 114 million barrels of oil equivalent (mmboe).
Oil in million Sm
3
Gas in billion Sm
3

FIGURE 16 PRODUCTION PROFILE FROM FIELD ALPHA

Field Bravo and Field Charlie
If we add field Bravo and Charlie, total commercially recoverable resources are estimated at 18 million sm
3
of
oil and around 5.2 billion sm
3
of gas. The high recovery in Bravo is due to very good reservoir properties,
while Alpha is more complex with varying sand quality. Charlie has a relatively good recovery due to
expected good pressure support from the natural water drive.
Fields
Reserves-in-place in
Recovery Factor Ultimate Recovery in

Oil Gas Oil Gas Oil Gas
Alpha 35.0m 9.1b 39% 47% 13.8m 4.3b
Bravo 4.0m 1.0b 63% 63% 2.6m 0.6b
Charlie 3.2m 0.6b 50% 50% 1.6m 0.3b
42.2m 10.7b 18.0m 5.2b

TABLE 8 ESTIMATED ULTIMATE RECOVERY OF FIELD ABC

pg. 34

Abandonment

FIGURE 17 ABANDONMENT/ DECOMMISSIONING OF AN OFFSHORE OIL FIELD

Abandonment costs are the cost incurred to meet the requirement for oil and gas producers to clean up after
themselves when production has finished, usually by plugging disused wells and dismantling facilities. By
definition, much of this constitutes the last activity in the life of the field, most of which occurs after revenue
from production has ceased. (Kasriel & Wood, 2013) A preliminary estimate shows that additional
decommissioning and removal cost will amount NOK 2.73 billion for field Alpha, NOK 0.48 billion for field
Bravo, and NOK 0.29 billion for field Charlie.

pg. 35

Economics

Capital expenditure (Capex)
Capex estimate for the field Alpha at NOK 19.43 billion for the period 2013 to 2018. Major Capex are
acquiring seismic, building platform (topside and jacket), leasing drill rig, laying pipeline, hiring
accommodation vessels, offshore heavy lifting, drilling campaign, and completing the wells. Field Bravo and
Charlie attract NOK 3.60 billion and NOK 1.27 billion Capex respectively. As described in Petroleum Tax Act
(PTA) section 3, the Company can depreciate Capex linear over a 6 years period.
Acquiring Seismic, Drilling Campaign, and Completing the Wells 11,8 billion NOK

Platform (Topside and Steel Jacket) 5,2 billion NOK Drilling Rig Lease 4,3 billion NOK

Pipeline 2,0 billion NOK Subsea Installation 1,0 billion NOK

FIGURE 18 MAJOR CAPITAL EXPENDITURES

pg. 36

Operating Expenditure
Tariff costs will be accrued related to the use of the Delta fields production systems and power supply, use of
the pipeline for transport of oil, and use of SAGE pipeline system on UK continental shelf for transport of gas.
Average operating expenses for field installations and wells, including tariffs and power supply, will amount to
around NOK 800 million annually from year 2012-2028 for field Alpha. Field Bravo annual operating expense
from year 2018-2028 is around NOK 170 million, and Charlie from year 2016-2028 is NOK 100 million. Total
Operating expense for all the field is approx. NOK 16.7 billion.
Tax system and Fees
The Norwegian petroleum tax system is, to large extent, based on taxation of net profits with a high marginal
tax rate of 78%. This consists of 28% general income tax and additional 50% special tax on income from
petroleum activities. In addition, environmental taxes such as CO2 and NOx are charged, and an area fee.
With a marginal tax rate of 78%, deductible costs are important aspect of the tax system. As general rule, all
costs incurred to earn taxable income are deductible. Investment may not be deducted immediately. As
described in Petroleum Tax Act (PTA) section 3, the Company can depreciate Capex linear over a 6 years
period. Under the PTA section 5, the Special tax basis shall be reduced with an uplift, which is set at 7.5% of
the cost price of depreciated assets. The uplift is allowed over 4 years, i.e. totaling 30% of investment.
The key features of the system are as follows:
+ Operating income
- Operating costs
- Depreciations (linear over 6 years)
- Exploration expenses, Research and Development, Plugging and Abandonment
- Environmental taxes
- Allocated financial costs
= General income tax base (28%)
- Uplift (7.5% investment for 4 years)
= Special tax base (50%)
(Jansen & Bjerke)
Other Economic assumptions
8

The Norwegian Petroleum Directorate has determined guidelines to be used by companies applying for
licenses on the Norwegian continental shelf. The Company aim to submit the petroleum production license
during the 22
nd
licensing round and the following economic assumptions must be followed.
Discount rate: 7%
Oil price: 2,708 NOK/ Sm
3
(69 USD/bbl.)
Gas price: 1.91 NOK/ Sm
3

Exchange rate: 6.20 NOK/ USD
Cost related to CO
2
: 20 NOK/ Sm
3
oil equivalent (o.e.)
Cost related to NO
x
: 10 NOK/ Sm
3
o.e.

It is decided during the meeting to use more realistic oil and gas price forecast and discount rate.

8
Source: 22
nd
licensing round: Guide to Production License Application

pg. 37

Case Questions

(A) Calculate the cost of capital

(B) Forecast the oil price for year 2012-2030

(C) Create a Financial Model for year 2012-2030

(D) Perform Monte Carlo Simulation on current Financial Model

(E) Create a Decision Tree analysis

(F) Create financial estimates for each scenario

(G) Perform Monte Carlo Simulation on the Decision Tree

pg. 38

Chapter 9 Proposed Solutions
9

Discount Rate

Risk-free rate

Risk free rate is the theoretical rate of return of an investment with zero risk. The risk free rate represents the
interest investor would expect from an absolutely risk-free investment over a specified period of time.
Based on study, the 10-year government bond is mainly applied as risk-free rate in the Norwegian market,
which means the implied risk free rate is 2%. (PriceWaterhouseCoopers, 2013)
Market risk premium

Required market risk premium is the incremental return of a diversified portfolio (the market) over the risk-
free rate required by an investor.
Based on study, the market risk premium in the Norwegian market is 5% for year 2012 and 2013. The risk
premium is unchanged from year 2011. (PriceWaterhouseCoopers, 2013)
Small stock premium

A small stock premium is an addition to the required rate of return on equity as a result of small companies
stocks historically being more volatile than larger companies and awarding investors with higher return.
Investors therefore warrant an additional premium Small companies are also often associated with higher risk
due to factors such as greater dependence on key personnel, individual products or customers.
Based on study, the small stock premium increases the smaller the size of the company. For companies with
a market capitalization of 2-5 billion, a premium of 0-1 % should be applied. For companies with a market
capitalization of 0.5-1 billion, a premium of 2-3 % should be applied. For companies with a market
capitalization of 0.1-0.5 billion, a premium of 3-4 % should be applied. (PriceWaterhouseCoopers, 2013)
Discount Rate for Kukuza Offshore Oilfield

Based on above information, the Author decides that the reasonable rate of return is 9%.

9
This proposed solution was prepared by Andika Rivai arivai@mba14.rsm.nl

pg. 39

Forecasting Oil Price
Revenue is the foundation to forecast cash flow. In Upstream Business, Revenue is defined as units of crude
oil and natural gas produced and sold, multiplied by a commodity price. Both volume and price are highly
uncertain and difficult to forecast. The Author suggests two stochastic approaches to forecast oil price: (1)
brownian motion and (2) mean-reverting.
Brownian motion (Random Walk) with Drift
Using Risk Simulator software, the start value is using the $ 69 economic assumption mentioned in the case
document. Drift rate 3% is inspired from Hotelling
10
principle. The 28% is implied volatility of oil price from
historical data 20 years back. Horizon is 20 years ahead, with 240 steps and 100 iterations.
Stochastic Process: Brownian Motion (Random Walk) with drift
Start Value ($) 69 Steps 240
Drift Rate 3% Iterations 100
Volatility 28% Reversion Rate n/a
Horizon (Years) 20 Long-Term Value n/a

TABLE 9 INPUT DATA FOR RISK SIMULATOR

After input above data, the software will simulate Brownian motion (random walk) with drift, and the
stochastic result is below (figure 19). The graphic illustrate different path from 100 iterations, and the table is
the mean of annual oil price from year 2016 to 2029. This is the period when the Company is expected to
produce oil and gas and generate revenue.

2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029
75.9 85.2 90.1 93.3 98.9 98.9 97.0 106.9 113.5 115.8 125.0 134.2 128.0 130.1

FIGURE 19 BROWNIAN MOTION STOCHASTIC RESULT

10
Harold Hotelling, and Economist at Columbia University, had an incredible idea: traders expect the price of a non-
renewable natural resource to rise at a rate equal to the interest rate. We call this idea the Hotelling Principle.

pg. 40

Mean-Reversion Process with Drift
Using Risk Simulator software, the start value is using the $ 69 economic assumption mentioned in the case
document. Drift rate 3% is inspired from Hoteling principle. The 28% is implied volatility of oil price from
historical data 20 years back. Horizon is 20 years ahead, with 240 steps and 100 iterations. In addition we
assume that reversion rate is also 3%, with long-term oil price at $ 100.
Stochastic Process: Mean-Reversion Process with drift
Start Value ($) 69 Steps 240
Drift Rate 3% Iterations 100
Volatility 28% Reversion Rate 3%
Horizon (Years) 20 Long-Term Value ($) 100

TABLE 10 INPUT DATA FOR RISK SIMULATOR

After input above data, the software will simulate mean-reversion with drift, and the stochastic result is below
(figure 20). The graphic illustrate different path from 100 iterations, and the table is the mean of annual oil
price from year 2016 to 2029. This is the period when the Company is expected to produce oil and gas and
generate revenue.

2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029
100.6 99.4 99.7 100.2 99.6 98.9 99.4 99.0 100.9 101.0 100.2 101.1 100.3 99.51

FIGURE 20 MEAN-REVERSION STOCHASTIC RESULT

pg. 41

It is suggested to compare the simulation result with external source. This is to make sure that our forecast is
not completely off from what other market participants point of view. Next the Author will compare the result
with Annual Energy Outlook (AEO) 2014 forecast
11
from US Energy Information Administration.
Comparison to Annual Energy Outlook (AEO) 2014 forecast
According to US EIA, the key determinants of petroleum long-term supply and prices can be summarized in
four broad categories: (1) the economics of non-OPEC supply; (2) OPEC investment and production
decisions; (3) the economics of other liquids supply; and (4) world demand for petroleum and other liquids.
Key assumptions driving global crude oil markets in the AEO2014 Reference case over the projection period
include: average economic growth of 1.9% per year for major U.S. trading partners and average economic
growth of 4.0% per year for other U.S. trading partners. Growth in petroleum and other liquids use occurs
almost exclusively outside the Organization for Economic Cooperation and Development (OECD) member
countries, with 1.8% average annual growth in petroleum and other liquids consumption by non-OECD
countries, including significantly higher average annual consumption growth in both China and India.
(US Energy Information Administration, 2013)

2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029
93.4 91.8 92.5 94.4 96.6 99.0 101.6 104.2 106.7 109.0 110.9 113.3 115.3 117.3

FIGURE 21 COMPARISON TO AEO2014 FORECAST

In figure 21 the author compare historical oil price, with the future forecast from scenario: (1) The Brownian
motion, (2) The Mean Reversion, and (3) AEO2014 forecast. Selecting which price to choose is a matter of
professional judgment, since no one can really predict the future accurately. In this thesis the Author choose
to use price forecast from the Brownian motion.

11
http://www.eia.gov/forecasts/aeo/er/index.cfm

pg. 42

Traditional Valuation Model

Revenue
To forecast the revenue we need to have the production schedule. Table 8 in the case document provide the
ultimate recovery data for field Alpha, Bravo, and Charlie, which is 18 million sm
3
of oil and around 5,2 billion
sm
3
of gas. The Case document also provides a production schedule only for field Alpha (see figure 16).
Based on this information the Author can estimate the same production characteristic for field Bravo and
Charlie. Once the production schedule is set, the Author can calculate the revenue.
Operating Expenses
The case document doesnt detail much the operating expenses (opex). Total Operating expense for all the
field is approx. NOK 16.7 billion. Total opex for field Alpha is NOK 13.46 billion, field Bravo is NOK 1.96
billion, and field Charlie NOK 1.28 billion. Below is a forecasted operating expense for the three fields
2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028
0.20 0.30 0.40 0.50 0.73 0.92 0.85 0.93 1.39 0.93 0.85 1.08 0.85 0.85 0.77 1.00 0.93
0.16 0.17 0.26 0.17 0.16 0.20 0.16 0.16 0.15 0.19 0.17
0.07 0.08 0.09 0.10 0.15 0.10 0.09 0.12 0.09 0.09 0.08 0.11 0.10

TABLE 11 OPERATING EXPENSE FORECAST FOR FIELD A, B, AND C

Capital Expenditure
Based on project schedule information in Table 7, and capital expenditure data (see figure 18) in the case
document to forecast the amount (How Much) and time (When) of investment capital.

FIGURE 22 CAPITAL EXPENDITURE FORECAST FOR FIELD A, B, AND C

pg. 43

After the discount rate is determined, and oil price forecast is set, the Author can now start creating the
financial model that consist of (1) Profit Loss, (2) Balance Sheet, (3) Cash Flow, and (4) Valuation.
Necessary information to create the financial model is given in the case document.
Field Alpha

FIGURE 23 PROFIT LOSS (SIMPLIFIED)

Field Alpha

FIGURE 24 BALANCE SHEET (SIMPLIFIED)

Field Alpha

FIGURE 25 CASH FLOW (SIMPLIFIED)

pg. 44

Field Alpha

FIGURE 26 VALUATION MODEL

Similar exercise is also done for the other two fields, Bravo and Charlie. The Author then prepares a
consolidated financial model for field Alpha-Bravo-Charlie (ABC). The comparison between development for
field Alpha only and development for field ABC in the same time is presented in table 12 below.
Field Alpha Field Alpha-Bravo-Charlie

TABLE 12 NPV AND APV OF FIELD ALPHA AND FIELD ABC

pg. 45

Monte Carlo Simulation
The previous static discounted cash flow produces only a single-point estimate result. To better estimate the
actual value of the offshore project, Monte Carlo simulation will be employed next.
Define Input Assumptions
The next step is to set input assumptions in the financial model. The Author has identified that in this offshore
project, there are 7 factors that play a major role in the NPV outcome. Those factors are: (1) oil price, (2)
exchange rate, (3) debt interest rate, (4) oil volume, (5) gas price, (6) gas volume, (7) capital expenditure,
and (8) operating costs.
Factors
Risks
Comments
Private Market
Oil price

Normal distribution with mean $ 101.67. This is
the average price from year 2012-2030
Exchange rate

Triangle distribution. Lowest 4.96/ 1$, Mean
6.20/ 1$, and Highest 7.44/ 1$
Debt interest rate

Triangle distribution. Lowest 7.6%, Mean
8.4%, and Highest 9.3%.
Oil volume

Triangle distribution. Lowest is 0.7 x Mean.
Mean is 18 million sm3. Highest is 1.3 x Mean
Capital expenditures

Mean is NOK 19.4b for field Alpha (NOK 24.3b
for field ABC). Highest is 1.2 x Mean
Gas volume

Mean is 5.2 billion sm3. Highest is 1.3 x Mean
Gas price

Gas price movement follow oil price
Operating costs

Operating cost is variable to oil and gas
production volume

TABLE 13 INPUT FOR MONTE CARLO SIMULATION

After above inputs are defined in the financial model, the next step is to perform the simulation. The Author
performed simulation with 10,000 iterations, essentially perform 10,000 sensitivity analysis given different
sets of probabilities. Figure 27 is the result for field Alpha only, and Figure 28 is the result for field ABC. The
simulation is executed using @ Risk version 6, Palisade Decision Tools.
From figure 27 Field Alpha NPVs are ranging from NOK -4.096 to NOK +6.190, with mean NOK +0.759. The
tornado chart shows that the ranking of factors affecting NPV. Oil price is number one, followed by oil
volume, exchange rate, capital expenditure, and the last is gas volume. The distribution is looks normal.
From figure 28 Field ABC NPVs are ranging from NOK -4.443 to NOK +8.230, with mean NOK +1.421. The
tornado chart shows that the ranking of factors affecting NPV. Oil price is number one, followed by oil
volume, exchange rate, capital expenditure, and the last is gas volume. The distribution is looks normal.

pg. 46

Simulation Results

FIGURE 27 MONTE CARLO SIMULATION FOR FIELD ALPHA ONLY

pg. 47

FIGURE 28 MONTE CARLO SIMULATION FOR FIELD ABC

pg. 48

Decision Tree
This is the start of the main idea behind this thesis. The Author believes that different kind of risk should be
handled differently. Market risk (which is totally outside Management control) should be accounted by Monte
Carlo simulation, while Private risk should be accounted by Decision Tree. Capital expenditure and operating
cost should be accounted by both. This is the main idea behind Integrated Approach

Factors
Risks
Comments Private Market
Oil price Monte Carlo simulation
Gas price Monte Carlo simulation
Exchange Rate Monte Carlo simulation
Debt Interest Monte Carlo simulation
Capital Expenditure Both
Operating Cost Both
Oil Volume Decision Tree
Gas Volume Decision Tree

TABLE 14 HOW TO ACCOUNT UNCERTAINTY

To create the decision tree, we need to understand the timeline of the project (see table 7), the strategic
options available to the Management, and subjective probabilities of events (e.g. oil and gas reservoir). In
case of Kukuza Offshore Oilfield, what Ben (the Finance Manager) can do is to set a meeting with Sean (the
COO) and try to understand what are the strategic options and subjective probabilities of the oil and gas
reservoir size, and how the reservoir size will drive other cost items, such as capital expenditure.
Meeting Notes (with Sean)
The Company will start building the steel jacket for the platform in year 2013. In year 2014 will be the
topsides (main support module, process module, flare boom and living quarters). Steel jacket will be put in
place by a large crane vessel in year 2015, and then a jackups rig will arrive to start the drilling campaign.
After pre-drilling result of 5 wells in Field Alpha is obtained by the end of year 2015, the Management has 2
choices in year 2016: to continue or to abandon. If it choose to continue, by year 2016 need to decide
whether to expand directly to field Bravo and Charlie or wait until drilling campaign in field Alpha finished.
If the Management chooses to expand directly in year 2016, there are 3 possible outcomes. (1) The reservoir
size for all three fields is large. In quantity, this means 1.3 x base case. Probability is 20%. (2) The reservoir
size for all three fields is medium. In quantity this means 1.0 x base case. Probability is 50%. (3) The
reservoir size for all three fields is small. In quantity this means 0.7 x base case. Probability is 30%.
If the Management chooses to wait, and continue with Field Alpha only in year 2016, the field Alpha reservoir
size chances are: (1) Large 20%, (2) Medium 50%, and (3) Small (30%). By year 2018, the Company will
have the full picture of actual reservoir size for field A. If the size of field A is either large or medium, the
Company still has an option to expand to field Bravo and Charlie by year 2019. Because the value of
information, reservoir size chances for field Bravo and Charlie if field A is large: (1) Large 30%, (2) Medium
60%, and (3) Small (10%). If field A is medium: (1) Large 20%, (2) Medium 70%, and (3) Small (10%). If field
Alpha is small, by default company will continue with field Alpha only.
There are some flexibility in managing the Capex Large field will result 10% higher Capex, while small field
will result 10% lower Capex compared to the base line.

pg. 49

Decision Tree Analysis

FIGURE 29 DECISION TREE ANALYSIS

pg. 50

Scenarios
After constructing decision tree, the Author finds out that there are 13 different scenarios that represent
sequence of events and probable outcomes of diversifiable risk (i.e. size of reservoir and managerial
flexibility (option to expand, continue, or abandon). The NPV calculation for each scenario is in Appendix.
Scenario
NPV
NOK billion
2015 2016 2017 2018 2019 2020
Option Option ... Event Option Event
Scenario 01 1.86
Continue
Field A
Expand
to Field B, C
...
Large
Field ABC
... ...
Scenario 02 1.47
Continue
Field A
Expand
to Field B, C
...
Medium
Field ABC
... ...
Scenario 03 0.91
Continue
Field A
Expand
to Field B, C
...
Small
Field ABC
... ...
Scenario 04 3.03
Continue
Field A
Wait ...
Large
Field A
Expand to
Field B, C
Large
Field BC
Scenario 05 3.06
Continue
Field A
Wait ...
Large
Field A
Expand to
Field B, C
Medium
Field BC
Scenario 06 2.84
Continue
Field A
Wait ...
Large
Field A
Expand to
Field B, C
Small
Field BC
Scenario 07 2.39
Continue
Field A
Wait ...
Large
Field A
Not
Executed
...
Scenario 08 1.94
Continue
Field A
Wait ...
Medium
Field A
Expand to
Field B, C
Large
Field BC
Scenario 09 1.72
Continue
Field A
Wait ...
Medium
Field A
Expand to
Field B, C
Medium
Field BC
Scenario 10 1.38
Continue
Field A
Wait ...
Medium
Field A
Expand to
Field B, C
Small
Field BC
Scenario 11 0.81
Continue
Field A
Wait ...
Medium
Field A
Not
Executed
...
Scenario 12 -0.93
Continue
Field A
Wait ...
Small
Field A
Not
Executed
...
Scenario 13 -1.46
Abandon
Field A
... ... ... ... ...

TABLE 15 SCENARIO ANALYSIS

As can be seen in figure 29, the result of Decision Tree suggests the following strategy: Continue developing
field Alpha in year 2015 and expand to field Bravo, Charlie in year 2016. Then there will be 3 possible
outcomes: large field, medium field, or small field with probabilities 0.2, 0.5, and 0.3 respectively. Estimated
NPV from the suggested strategy is NOK 1.37 billion.
Although decision tree already account Management flexibility and private risk (reservoir size), again the
decision tree only provide a single point suggestion, which not yet accounted volatility in the market risks
(e.g. oil price). The next part the Author will present his suggestion on how to tackle this issue.

pg. 51

Valuing Flexibility
The integrated approach begins by noting that there are two types of risk associated with most corporate
investments: public (non-diversifiable) and private (diversifiable). The integrated approach acknowledges that
most investment problems have both kind of risk and it is designed to address that very situation.
The integrated approach involves the following steps:
Build a decision tree representing the investment alternatives
Identify each risk as either public or private
For private risks, assign subjective probabilities
Apply a spreadsheet cash-flow model at each tree end point, and calculate the NPV
Roll back the tree to determine the optimal strategy and its associated value
Perform Monte Carlo simulation for public risks in the decision tree; the result will be different sets of
optimal strategy for different circumstances, and a distribution of real options valuation.
The above explanation can be summarized in figure 30 below.

FIGURE 30 THE INTEGRATED APPROACH

pg. 52

Define Input Assumptions
The next step is to set input assumptions in the financial model, see table 16.
Factors
Risks
Comments
Private Market
Oil price

Normal distribution with mean $ 101.67. This is
the average price from year 2012-2030
Exchange rate

Triangle distribution. Lowest 4.96/ 1$, Mean
6.20/ 1$, and Highest 7.44/ 1$
Debt interest rate

Triangle distribution. Lowest 7.6%, Mean
8.4%, and Highest 9.3%.
Oil volume

Not Applicable the subjective probability
already accounted by Decision Tree
Capital expenditures

50% accounted by Decision Tree, 50%
accounted by Monte Carlo Simulation
Gas volume

Not Applicable the subjective probability
already accounted by Decision Tree
Gas price

Gas price movement follow oil price
Operating costs

50% accounted by Decision Tree, 50%
accounted by Monte Carlo Simulation

TABLE 16 INPUT FOR MONTE CARLO SIMULATION

After above inputs are defined in the 13 financial models, the next step is to perform the simulation on
the decision tree. The Author performed simulation with 10,000 iterations, essentially perform 10,000
sensitivity analysis given different sets of probabilities. Figure 31 is the result. The simulation is executed
using @ Risk version 6, Palisade Decision Tools.

pg. 53

Simulation Results

FIGURE 31 MONTE CARLO SIMULATION ON THE DECISION TREE

pg. 54

Chapter 10 Conclusion
It is demonstrated in the case study that it is both practically and theoretically possible to use Real Options
Valuation approach for upstream project. To do this, the Author use the integrated risk management process
and modified one step by using an integrated approach as a way to value flexibility. In this chapter, the
Author will discuss Real Options impact to NPV and Decision Making.

Net Present Value (NPV) Analysis
The integrated approach resulted with a probability distribution that combines real options, diversifiable risk,
and non-diversifiable risk effects: The right-hand side of the distribution has fatter tails (upward potential),
while losses on the downside are clearly cut off.
Result Comments

FIGURE 32 NPV DISTRIBUTION WITHOUT FLEXIBILITY

From the case study Kukuza Offshore
Oilfield the original mean NPV for field
Alpha is NOK 0.76 billion. The downside
risk is NOK -4.1 billion, and the upward
potential is NOK 6.19 billion. See figure 32

With inclusion of management flexibility to
abandon and to expand, the value increase
to NOK 1.77 billion. The probability
distribution combines the individual option
effects:

(1) The right-hand side of the distribution
has fatter tails (reflecting upward
potential) because there is an option to
expand, with maximum value of NOK
7.67 billion

(2) While losses on the downside are
clearly cut off because there is
abandonment option that limits the lost
to NOK -1.45 billion.

See figure 33

FIGURE 33 NPV DISTRIBUTION WITH FLEXIBILITY

pg. 55

Decision Analysis
Previously, the result of Decision Tree suggests the following strategy: Continue developing field Alpha in
year 2015 and expand to field Bravo and Charlie in year 2016.
Is this still the optimal decision after running Monte Carlo simulation?
Result (1st abandon decision in Year 2015) Comments

FIGURE 34 DECISION CHOICE ABANDON OR CONTINUE

To understand how changes in non-diversifiable
risk can impact decision making, the Author set the
counter on decisions when running the Monte
Carlo simulation on decision trees. TRUE is set as
0 and False is set as 1

For the first decision option, in 10,000 simulations,
almost in all circumstances suggest continuing.
There are a very small number of events (56
times!) that optimal decision is to abandon.

This result of incorporating market risk into the
decision tree and simulate it. In condition where
everything goes wrong in the market, the optimal
decision is to abandon.

In year 2015, when Management is going to
decide whether to continue or abandon the project,
critical factors are: Oil price, Exchange Rate, and
Capex.

Note: Abandon decision in here represent
Scenario 13

FIGURE 35 TORNADO CHART IMPACTING DECISION CHOICE
ABANDON OR CONTINUE

pg. 56

Result (1st expand decision in Year 2016) Comments

FIGURE 36 DECISION CHOICE CONTINUE OR EXPAND

risk can impact decision making, the Author set the
counter on decisions when running the Monte
Carlo simulation on decision trees. TRUE is set as
0 and False is set as 1

For the second decision option, in 10,000
simulations, majority (close to 60%) suggest to
expand in Year 2016. But, there is considerable
number of event (40%) that optimal decision is
to continue with field Alpha only, and wait for
year 2019 for the second chance of expansion
decision.

This resulting from incorporating market risk into
the decision tree and simulate it.

critical factors are: Capex, Exchange Rate, and Oil
price.

Note: Expand Decision in here Represent
Scenario 1, 2, and 3.

FIGURE 37 TORNADO CHART IMPACTING DECISION CHOICE TO
CONTINUE OR EXPAND

pg. 57

If in 2016 the Management decided to wait and continue with field Alpha only, by the year 2019 the
Management will have second chance for expansion decision. In year 2019, such event can fall under 2
different scenarios on the reservoir size of field Alpha (that Management will find out by year 2018). The 1st
scenario is the actual reservoir size of field Alpha is large, and the 2nd scenario is medium reservoir size.
Result (2nd expand decision in Year 2019) Comments


Scenario Large Reservoir

risk can impact decision making, The Author also
set the counter on decisions when running the
Monte Carlo simulation on decision trees. TRUE is
set as 0 and False is set as 1

If in year 2016 Management opt to wait, in year
2019 Management will have second chance to
decide whether to expand to field Bravo and
Charlie of stay with field Alpha only.

For the third decision option, in 10,000
expand in Year 2019. But, in some situation
(less than 10%) that optimal decision is to
continue with field Alpha only.


critical factors are: Capex, Exchange Rate, and Oil
price.

Note: this is for the scenario reservoir size
Field A is large, scenario 4, 5, 6, and 7

CONTINUE OR EXPAND

pg. 58

Result (2nd expand decision in Year 2019) Comments


Scenario Medium Reservoir

The Author also set the counter on decisions
when running the Monte Carlo simulation on
decision trees. TRUE is set as 0 and False is set
as 1

If in year 2016 Management opt to wait, in year
2019 Management will have second chance to
decide whether to expand to field Bravo and
Charlie of stay with field Alpha only.

For the third decision option, in 10,000
expand in Year 2019. But, still considerable
number of event (20%) that optimal decision is
to continue with field Alpha only.


critical factors are: Capex, Oil Price, and Exchange
Rate.

Note: this is for the scenario actual reservoir
size Field A is medium or small, scenario 8, 9,
10, 11, and 12

CONTINUE OR EXPAND

pg. 59

Conclusion

Upstream project is a risky business; it cost a lot to develop an entire oil field in an environment
with much uncertainty. In the case study, the expected project value from initial DCF analysis is
NOK 0.8 billion. Monte Carlo simulation shows that the actual value can be anywhere between
NOK -4.1 billion to NOK 6.2 billion.

With application of decision analysis, the project value increased to NOK 1.4 billion, with thirteen
different scenarios. The recommended strategy is to continue developing field Alpha in 2015 and
expand to field Bravo and Charlie in 2016.

Decision tree already incorporate managerial flexibility, however, the weakness it is still ignoring
non-diversifiable risk, which in theory can be captured by Real Options. To address this weakness,
another Monte Carlo simulation can be applied to the Decision Tree. All non-diversifiable risk, such
as oil price and exchange rate are simulated randomly to all possible scenarios. The simulation
with 10,000 iterations shows that the actual value can be anywhere between NOK -1.5 billion to
NOK 7.7 billion.

Unlike Decision Tree that only present one optimal strategy, simulation give a range of optimal
strategies and indicated the probability of such strategy will be executed in the future. In year 2015,
there is only 1% chance to abandon the project, and 99% chance to continue. In year 2016, both
expansion and continue option are possible, with probability 60% and 40% respectively. This will
be a critical year, and Management will need to carefully decide which option to choose. In case
Management decide not to expand, in 2018 they will have another decision chance. The simulation
shows that if the reservoir size of field Alpha is medium to large, the possibility to expand is
between 80%-90%.

Overall, this thesis showed that real option analysis does add valuable insight on valuation and
decision making. It also illustrated that real option can be approached through combination of
decision tree and Monte Carlo simulation, which is more user-friendly than classical approach
such as Black and Scholes or binomial tree.

Future Research

This method is promising due to it simplicity. The Author recommend for future researcher to test
the valuation accuracy, by comparing the same case study using different real options approaches.

pg. 60

Works Cited
A.Galli, & Armstrong, M. (1999). Comparing Three Methods for Evaluating Oil Projects: Option Pricing,
Decision Trees, and monte Carlo Simulations. SPE International.
Anthony, R. N., Hawkins, D. F., & Merchant, K. A. (2011). Accounting: Text and Cases 13th Edition.
Singapore: McGrawHill.
Avinash K. Dixit, R. S. (1994). Investment Under Uncertainty. Princeton: Princeton University Press.
Bailey, W. (2006). Schlumberger on Real Options in Oil and Gas. In J. Mun, Real Option Analysis: Tools and
techniques for valuing strategic investments and decisions (pp. 44-48). New Jersey: John Wiley &
Sons, Inc.
Borison, A. (2005). Real Options Analysis: Where are the Emperor's Clothes. Journal of Applied Corporate
Finance, 17-31.
Brady, J., Chang, C., Jennings, D. R., & Shappard, R. (2011). Petroleum Accounting 7th Edition. Denton:
Professional Development Institute.
Brealey, R. A., Myers, S. C., & Allen, F. (2011). Principles of Corporate Finance. Singapore: McGraw-Hill.
Coopersmith, E., Dean, G., McVean, J., & Storaune, E. (2001). Making Decisions in the Oil and Gas Industry.
Oilfield Review, pp. 2-9.
Dias, M. A. (2004). Valuation of exploration and production assets: an overview of real options models.
Journal of Petroleum Science and Engineering, 93-114.
James E. Smith, K. F. (1999). Options in the real world: Lessons learned in evaluating oil and gas
investments. Operations Research.
Jansen, J. B., & Bjerke, J. M. (n.d.). Norwegian Petroleum Taxation. Oslo: BAHR.
Kasriel, K., & Wood, D. (2013). Upstream Petroleum Fiscal and Valuation. West Sussex: John Wiley & Sons.
Maeseneire, W. D. (2006). The Real Options Approach to Strategic Capital Budgeting and Company
Valuation. Brussel: The Boeck & Larcier NV.
McKinsey & Company. (2010). Valuation. New Jersey: John Wiley & Sons, Inc.
Mun, J. (2006). Real Options Analysis. New Jersey: John Wiley & Sons.
Mun, J. (2006). Real Options Analysis versus Traditional DCF Valuation in Layman's Terms. Dublin: Real
Options Valuation, Inc.

pg. 61

Mun, J. (2010). Modeling Risk. New Jersey: John Wiley & Sons, Inc.
PriceWaterhouseCoopers. (2013). The Norwegian Market Risk Premium 2012 and 2013. Oslo:
PriceWaterhouseCoopers.
Suslick, S. B., Schiozer, D., & Rodriguez, M. R. (2009). Uncertainty and Risk Analysis in Petroleum Exploration
and Production. Terrae, 30-41.
The University of Texas at Austin - PETEX. (2011). Fundamentals of Petroleum. Houston: The University of
Texas at Austin - PETEX.
US Energy Information Administration. (2013, December 16). AEO2014 EARLY RELEASE OVERVIEW.
Retrieved February 13, 2014, from US Energy Information Administration:
http://www.eia.gov/forecasts/aeo/er/index.cfm
Walsh, C. (2008). Key Management Ratios 4th Edition. Harlow: Pearson Education Limited.

pg. 62

List of Figures and Tables

Figures

Figure 1 integrated risk management process .................................................................................................. 6
Figure 2 Value chain of the upstream petroleum industry ................................................................................ 9
Figure 3 A typical E&P cash-flow project (Suslick, Schiozer, & Rodriguez, 2009) ............................................ 11
Figure 4 Monthly Average Crude Oil Price Jan 1975 to Jun 2012 .................................................................... 12
Figure 5 Monte Carlo, @ Risk .......................................................................................................................... 18
Figure 6 Example of Tornado plot oil and gas project (Coopersmith, Dean, McVean, & Storaune, 2001) ..... 19
Figure 7 Example of Decision Tree (Coopersmith, Dean, McVean, & Storaune, 2001) ................................... 20
Figure 8 When is Flexibility Valuable? ............................................................................................................. 23
Figure 9 Application Opportunities for ROV versus DTA (McKinsey & Company, 2010) ................................. 25
Figure 10 Location of Field Alpha, Bravo, and Charlie ..................................................................................... 28
Figure 11 Structures and reservoir formations ................................................................................................ 29
Figure 12 Jackups drilling rig (CJ-70) to be used on Alpha ............................................................................... 30
Figure 13 Coordinated development of Field Alpha and Delta ....................................................................... 31
Figure 14 Platform ........................................................................................................................................... 31
Figure 15 Typical subsea installation ............................................................................................................... 32
Figure 16 Production profile from Field Alpha ................................................................................................ 33
Figure 17 Abandonment/ Decommissioning of an offshore oil field ............................................................... 34
Figure 18 Major Capital Expenditures .............................................................................................................. 35
Figure 19 Brownian Motion Stochastic Result ................................................................................................. 39
Figure 20 Mean-Reversion Stochastic Result ................................................................................................... 40
Figure 21 Comparison to AEO2014 forecast .................................................................................................... 41
Figure 22 Capital Expenditure Forecast for field A, B, and C ........................................................................... 42
Figure 23 Profit Loss (simplified) ...................................................................................................................... 43
Figure 24 Balance Sheet (simplified) ................................................................................................................ 43
Figure 25 Cash Flow (simplified) ...................................................................................................................... 43
Figure 26 Valuation Model ............................................................................................................................... 44
Figure 27 Monte Carlo Simulation for Field Alpha only ................................................................................... 46
Figure 28 Monte Carlo Simulation for Field ABC ............................................................................................. 47
Figure 29 Decision Tree Analysis ...................................................................................................................... 49
Figure 30 The Integrated Approach ................................................................................................................. 51
Figure 31 Monte Carlo Simulation on the Decision Tree ................................................................................. 53
Figure 32 NPV distribution without flexibility .................................................................................................. 54
Figure 33 npv distribution with flexibility ........................................................................................................ 54
Figure 34 decision choice abandon or continue .............................................................................................. 55

pg. 63

Figure 35 tornado chart impacting decision choice abandon or continue ...................................................... 55
Figure 36 decision choice continue or expand ................................................................................................ 56
Figure 37 tornado chart impacting decision choice to continue or expand .................................................... 56

Tables

Table 1 Thesis Structure ..................................................................................................................................... 8
Table 2 Data Input Needed for brownian motion ........................................................................................... 13
Table 3 Data Input Needed for mean-reversion .............................................................................................. 14
Table 4 DCF disadvantages (Mun J. , Real Options Analysis, 2006) ................................................................. 16
Table 5 Important factors in oil and gas project with their risk profile ........................................................... 19
Table 6 options/ choices Summarized from (Bailey, 2006) ............................................................................. 22
Table 7 Project schedule .................................................................................................................................. 32
Table 8 Estimated ultimate recovery of Field ABC ........................................................................................... 33
Table 9 input data for Risk Simulator ............................................................................................................... 39
Table 10 input data for Risk Simulator ............................................................................................................. 40
Table 11 Operating Expense Forecast for field A, B, and C .............................................................................. 42
Table 12 NPV and APV of Field Alpha and Field ABC ....................................................................................... 44
Table 13 Input for Monte Carlo simulation ..................................................................................................... 45
Table 14 How to account uncertainty .............................................................................................................. 48
Table 15 Scenario Analysis ............................................................................................................................... 50
Table 16 Input for Monte Carlo simulation ..................................................................................................... 52

pg. 64

Appendix
Scenario 1

pg. 65

Scenario 2

pg. 66

Scenario 3

pg. 67

Scenario 4

pg. 68

Scenario 5

pg. 69

Scenario 6

pg. 70

Scenario 7

pg. 71

Scenario 8

pg. 72

Scenario 9

pg. 73

Scenario 10

pg. 74

Scenario 11

pg. 75

Scenario 12

pg. 76

Scenario 13

pg. 77

About the author

Andika Rivai had 10+ years of experience as Consultant
and Finance Manager in PricewaterhouseCoopers and
Baker Hughes Inc. Oilfield Services. During his career, he
demonstrated financial management skills and ability to
collaborate effectively with peers, senior managers, and
internal clients. He has been posted in multiple locations
across Middle East and Asia Pacific in cities such as Perth,
Dubai, Beijing, Shekou, Duri, and Jakarta. He graduated in
March 2014 with MBA and MSc in Financial Management
from RSM, Erasmus University. His main interests are
financial modelling, valuation, and decision making. He
can be contacted at arivai@mba14.rsm.nl

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