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Project Evaluation: A Pracitcal Asset Pricing Method

This paper presents a practical approach to project evaluation using techniques of modern financial economics, with a sample application to oil development under a complex tax system. The method overcomes shortcomings of conventional discounted cash flow (DCF) methods which are either imprecise about the relation between economic value and uncertainty, or are rigid and unrealistic in the required assumptions about how a project's risks (and therefore its value) are influenced by market conditions, the project physical structure, and tax and contract provisions. It is based on the formulation and estimation of an "information model" which represents the resolution over time of uncertainties underlying a project (oil prices in the examples shown). The project can then be valued using derivative asset valuation, which replicates the consequences of a complex asset by a traded portfolio of simpler assets (in our case, riskless bonds and future claims on oil).

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Energy Specializations: Petroleum – Exploration and Production; Energy Modeling – Energy Data, Modeling, and Policy Analysis

JEL Codes:
D24 - Production; Cost; Capital; Capital, Total Factor, and Multifactor Productivity; Capacity
E61 - Policy Objectives; Policy Designs and Consistency; Policy Coordination

Keywords: Oil project valuation, Asset pricing methods, DCF analysis, Oil investment

DOI: 10.5547/ISSN0195-6574-EJ-Vol13-No2-2

Published in Volume 13, Number 2 of The Quarterly Journal of the IAEE's Energy Economics Education Foundation.