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Real Options SLisowski

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Real Options in Practice: Two Examples from the Energy Sector

Sue Lisowski - Texaco Inc.DAAG (Decision Analysis Affinity Group) 2000 Calgary, Canada - May 17-19, 2000

Outline What is different about Real Options? Modeling options and managerial flexibility Valuing cash flows

Example 1: New Technology Example 2: Offshore Opportunity Conclusion

Why Real Options Valuation (ROV) ?

Discounted Cash Flow (DCF)

Sensitivity Analysis

Simulation (Monte Carlo)

Decision Trees

Option Pricing

Real Options

Real Options Valuation (ROV) combines and extends DCF, Option Pricing, and Decision Analysis

The two dimensions of Real Options ValuationReal Options Valuation (ROV)

Discover Uncertainties, Options, & FlexibilityOpen Framing Dynamic Learning

Valuing Cash Flows(decomposed assessment)Private vs. Market Risks Risk-free Discounting

What are real options?Add Flexibility to Defer Project (Call Option)Rate Price Cost Rate Price Cost

Develop Quit

Develop Rate Price Cost

InformationWait Quit Develop

InformationWait Quit

Year 1

Year 2

Year 3 Lease expires in 2 years

What are real options?Add Flexibility to Abandon Project (Put Option)Salvage Value Rate Develop Continue Continue Price Costs Abandon Salvage Value Abandon

Rate Quit Develop

Price

Costs

Rate

Price

Costs

InformationWait Quit Develop

InformationWait Quit

Year 1

Year 2

Year 3

Value cash flows with appropriate risking Use option pricing to model market (e.g., price) risk: Apply risk-adjusted probabilities to capture risk premium (can determine from futures and options markets)

Use decision analysis to model private (e.g., volume) risk: Apply subjective probabilities to risk non-tradable assumptions (can determine from historical databases and expert assessments)

Discount the resulting risk-adjusted cash flows at risk-free discount rate

Who uses ROV?*Energy Investment Banks /Consultants Computer/Internet Telecommunication

* partial list

Learning Enhance subsequent decisions (option value) by incorporating learning on new information Learning occurs at differing speeds and in a variety of ways

Learning

Variance Reduced

Probability

Revised estimate after drilling a 210 bbl/day well

Mean Value Shifted 3 4 5 6

Log of Well Productivity (bbl/day)

Graphs courtesy of ADA(PwC)

ROV is not simply a better tool. It is an objective, all-embracing process.Decision MakersContinue Continue Action

Open Framing Analysis Strategic Environment Uncertainties Options, Flexibilities

Interpretation

Smart Modeling No regrets Strategy Uncertainty Assessment Dynamic Road-map Market Pricing Leveraging Uncertainties

Asset Team + Other Experts

Real Options Team

Example 1: New Technology From commercial standpoint, relatively unproven technology More than one source of technology, with providers at differing points in development and experience Anticipate variations in technology performance and costs, depending on provider

Questions Should we make a major commitment to this technology? What commercial opportunities exist for application of this technology in the long-term? In the short-term, on which commercial opportunities and technology provider(s) should we focus? How does commercial application of this technology look from a portfolio perspective?

Areas of major uncertainty For each provider, technology effectiveness and cost For each provider and location, installation and operational costs Prices of inputs and end-products Potential for non-technical delays Contractual terms and taxes in various locations

Decisions to be evaluated Which technology provider(s) should we use? Should we do more testing before committing to the technology? What implementation size is best? What implementation schedule is best? When should we take advantage of potential synergies?

Approach taken Modeled approximately 10 separate opportunities Evaluated 3 separate schedules Treated as a portfolio of opportunities Placed significant emphasis on learning from project to project within each schedule

Sources of option value

Fully Risked base case is: Technology Provider A No exit No synergy Nominal project size Base schedule

Fully Risked "base"

Exit option

Technology Project size provider option option

Synergy option

Total Value

Relative value of learning*With Options

10 0%

5% 0Without Options

0 %Fully Learning Risked Value Value,No Learning Fully Risked Value Fully Learning Risked Value Value,No Learning Fully Risked Value

* learning about technology, operating efficiency, operating costs, and capital costs

Keeping all technology providers available is the best choiceExpected Value

A

B

C

AB

AC

BC

ABC

No single provider is always the best choice For most opportunities, having a choice of technology providers is best

Example 2: Offshore Opportunity Harsh or unique conditions May be little or no infrastructure in place Costs are higher Operations more difficult Large reserves

Areas of major uncertainty Amount of oil and gas Recoverable oil and gas Drilling and platform costs Value of oil and gas Impact of delays Contractual terms, regulations, political issues, special environmental issues

Decisions to be evaluated What size should the platform be initially? Should the platform be expandable? When should we expand the platform? How much? Should the development plan be rapid or staged? Should we handle production from other opportunities?

Sources of option value

Fully risked base

Platform location

Platform size

Type of compl'n

Total Value

Optimal strategy mapBest Test Location

Delta

Connect to nearby platform

Medium platform

Large platform

Gamma

Exit

Medium platform

Large platform

Best Location Test Results = ALow Nominal High

Test Reserve Results

Results Calculations and AnalysisLow Yes Nominal No High High High High0.8

Low Nominal

Low Nominal

Low1

Nominal0.9

0.7

0.6

Low Nominal High

Low Nominal High

Low Nominal High

0.5

0.4

0.3

0.2

Opportunity workbook

Low Yes Nominal No High

Low Nominal High

Low Nominal High

Low Nominal High

Low Nominal High

Low Nominal High

0.1

0

Model Building

Expert Assessments

Open Framing Session

The long-term challenge is a cohesive, enterprise solution

StrategyReal Options Valuation Portfolio Optimization

ExecutionEnterprise Risk Management Value-Based Accountability

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