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The Management of Flexibility in the Upstream Petroleum Industry

This paper is the third in a series that describes how Modern Asset Pricing (MAP) may be used for project evaluation in the upstream petroleum industry. It demonstrates how MAP can be applied to projects where policies for the management of future flexibility must be considered within the context of the valuation. We illustrate this use of MAP by looking specifically at flexibility in the timing of the exploration, delineation, and development of an oil prospect, and the timing of the abandonment of the subsequent developed field. We use examples to show how the value and management of flexibility depends on the amount of oil price and reserve size uncertainty. We find that prospect value increases with both types of uncertainty. We also find that all actions, from exploration to abandonment, occur later with greater oil price uncertainty. Conversely, we find that exploration and delineation occur sooner with greater reserve uncertainty. The reasons for these results are given.

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

JEL Codes:
D24 - Production; Cost; Capital; Capital, Total Factor, and Multifactor Productivity; Capacity
G32 - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
C59 - Econometric Modeling: Other

Keywords: Oil, Modern asset pricing (MAP), upstream oil industry, oil prices, oil project development

DOI: 10.5547/ISSN0195-6574-EJ-Vol19-No1-4

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