Facebook LinkedIn Twitter

IAEE Members and subscribers to The Energy Journal: Please log in to access the full text article or receive discounted pricing for this article.

Petroleum Property Valuation: A Binomial Lattice Implementation of Option Pricing Theory

We take a simple tutorial approach to explain how option valuation can be applied in practice to the petroleum industry. We discuss a simple spreadsheet formulation, demonstrate how required input data can be extracted from market information, and give several exploration and development examples. Under the market and fiscal conditions described we derive the value of discovered, undeveloped reserves projected to result from offshore licensing in the United Kingdom, and we show how to determine the maximum amount that should be committed to an exploration work program to find those reserves. Lease-bidding and farm-out applications are briefly described. We recommend option valuation as an alternative to discounted cash flow analysis in situations where cash flows are uncertain and management has operating flexibility to adjust investment during the life of the project, and point to further work needed to fully value nested or embedded options.

Purchase ( $25 )

Energy Specializations: Petroleum – Exploration and Production; Energy Investment and Finance – Corporate Strategy; Energy Modeling – Other

JEL Codes:
D24 - Production; Cost; Capital; Capital, Total Factor, and Multifactor Productivity; Capacity
D92 - Intertemporal Firm Choice: Investment, Capacity, and Financing
C59 - Econometric Modeling: Other

Keywords: Oil property valuation, Option pricing theory, Finance, Exploration, Binomial lattice

DOI: 10.5547/ISSN0195-6574-EJ-Vol14-No2-1

Published in Volume 14, Number 2 of The Quarterly Journal of the IAEE's Energy Economics Education Foundation.