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Page 1: Real Options SLisowski

Real Options in Practice: TwoExamples from the Energy Sector

Sue Lisowski - Texaco Inc.DAAG (Decision Analysis Affinity Group) 2000

Calgary, Canada - May 17-19, 2000

Page 2: Real Options SLisowski

Outline

• What is different about Real Options?− Modeling options and managerial flexibility

− Valuing cash flows

• Example 1: New Technology

• Example 2: Offshore Opportunity

• Conclusion

Page 3: Real Options SLisowski

Why Real Options Valuation (ROV) ?

DiscountedCash Flow

(DCF)

SensitivityAnalysis

Simulation(MonteCarlo)

DecisionTrees

OptionPricing

RealOptions

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

Page 4: Real Options SLisowski

Valuing Cash Flows(decomposed assessment)

Private vs. Market Risks

Risk-free Discounting

Real Options Valuation (ROV)

Discover Uncertainties,Options, & Flexibility

Open Framing

Dynamic Learning

The two dimensions ofReal Options Valuation

Page 5: Real Options SLisowski

Lease expires in 2 years

Add Flexibility to Defer Project (Call Option)

Year 3

CostPrice

Develop

Rate

Quit Wait

Year 2

Develop

Quit

CostPriceRate

Year 1

Develop

Quit

Wait

What are real options?

Information

CostPriceRate

Information

Page 6: Real Options SLisowski

Add Flexibility to Abandon Project (Put Option)SalvageValue

Year 2

Abandon

Continue

Year 3

Abandon

SalvageValue

Continue

CostsPrice

Develop

Rate

Quit

Develop

Quit

Wait

What are real options?

Year 1

CostsPrice

Develop

Rate

Quit

Wait

Information

CostsPriceRate

Information

Page 7: Real Options SLisowski

Value cash flows withappropriate 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 databasesand expert assessments)

• Discount the resulting risk-adjusted cash flowsat risk-free discount rate

Page 8: Real Options SLisowski

Who uses ROV?*

EnergyComputer/InternetTelecommunication

* partial list

Investment Banks/Consultants

Page 9: Real Options SLisowski

Learning• Enhance subsequent decisions (option value)

by incorporating learning on new information

• Learning occurs at differing speeds and in avariety of ways

Page 10: Real Options SLisowski

Pro

bab

ility

Log of Well Productivity (bbl/day)3 4 5 6

Revisedestimate after

drilling a210 bbl/day well

ValueMean

Shifted

VarianceReduced

Graphs courtesy of ADA(PwC)

Learning

Page 11: Real Options SLisowski

Asset Team +Other Experts

Real OptionsTeam

Decision Makers

Open Framing– Strategic Environment– Uncertainties– Options, Flexibilities

Interpretation– “No regrets” Strategy– Dynamic Road-map– Leveraging Uncertainties

Analysis– “Smart” Modeling– Uncertainty Assessment– Market Pricing

Continue

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

Continue Action

Page 12: Real Options SLisowski

Example 1: New Technology

• From commercial standpoint, relativelyunproven technology

• More than one source of technology, withproviders at differing points in developmentand experience

• Anticipate variations in technologyperformance and costs,depending on provider

Page 13: Real Options SLisowski

Questions• Should we make a major commitment to this

technology?

• What commercial opportunities exist forapplication of this technology in the long-term?

• In the short-term, on which commercialopportunities and technology provider(s)should we focus?

• How does commercial application ofthis technology look from a portfolioperspective?

Page 14: Real Options SLisowski

Areas of major uncertainty

• For each provider, technology effectivenessand cost

• For each provider and location, installation andoperational costs

• Prices of inputs and end-products

• Potential for non-technical delays

• Contractual terms and taxesin various locations

Page 15: Real Options SLisowski

Decisions to be evaluated

• Which technology provider(s) should we use?

• Should we do more testing before committingto the technology?

• What implementation size is best?

• What implementation schedule is best?

• When should we take advantage ofpotential synergies?

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Approach taken

• Modeled approximately 10 separateopportunities

• Evaluated 3 separate schedules

• Treated as a “portfolio” of opportunities

• Placed significant emphasison learning from project toproject within each schedule

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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 Technologyprovider option

Project sizeoption

Total ValueSynergyoption

Page 18: Real Options SLisowski

0%

50%

100%

FullyRisked

Value, NoLearn ing

Learn ingValue

FullyRiskedValue

FullyRisked

Value, NoLearn ing

Learn ingValue

FullyRiskedValue

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

Without Options

With Options

Relative value of learning*

Page 19: Real Options SLisowski

Keeping all technology providersavailable is the best choice

• No single provider is always the best choice

• For most opportunities, having a choice oftechnology providers is best

A B C AB AC BC ABC

ExpectedValue

Page 20: Real Options SLisowski

Example 2: Offshore Opportunity

• Harsh or unique conditions

• May be little or noinfrastructure in place

• Costs are higher

• Operations more difficult

• Large reserves

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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

Page 22: Real Options SLisowski

Decisions to be evaluated

• What size should the platform be initially?

• Should the platform be expandable?

• When should we expand the platform? Howmuch?

• Should the development plan berapid or staged?

• Should we handle production fromother opportunities?

Page 23: Real Options SLisowski

Sources of option value

Fully riskedbase

Platformlocation

Platform size Type ofcompl'n

Total Value

Page 24: Real Options SLisowski

Optimal strategy mapB

est

Tes

t L

oca

tio

n

Low

Gamma

Delta

Best Location Test Results = A

Nominal High

Medium platform

Largeplatform

Exit

Connect to nearby platform

Test Reserve Results

Largeplatform

Medium platform

Page 25: Real Options SLisowski

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Opportunityworkbook

Expert Assessments Open Framing SessionModel

Building

ResultsCalculations and Analysis

Low

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Yes

No

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The long-term challenge is a cohesive,enterprise solution

StrategyReal Options

Valuation

PortfolioOptimization

ExecutionEnterprise Risk

Management

Value-BasedAccountability


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