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Implications of Output Price Risk and Operating Leverage for the Evaluation of Petroleum Development Projects

This paper is the first in a series that describes how Modem Asset Pricing (MAP) may be used for project evaluation in the upstream petroleum industry. It shows how MAP methods can be used to value a project, if it i's possible to split its cash-flows into two components: one for revenue and one for cost. Two design choices for a "now or never " natural gas field development are used as examples of what can be gained by this type of approach to project evaluation. The first choice involves a tradeoff between capital and operating costs, while the second involves a tradeoff between costs and potential production rate. The results show that the use of standard DCF methods can induce systematic, and possibly misleading, biases into the analyses that lie behind project design and selection.

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

JEL Codes:
D24 - Production; Cost; Capital; Capital, Total Factor, and Multifactor Productivity; Capacity
E60 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook: General
E61 - Policy Objectives; Policy Designs and Consistency; Policy Coordination

Keywords: Modern asset pricing, oil industry, oil project valuation, DCF methods

DOI: 10.5547/ISSN0195-6574-EJ-Vol19-No1-2

Published in Volume19, Number 1 of The Quarterly Journal of the IAEE's Energy Economics Education Foundation.