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Petroleum Prospect Valuation: The Option to Drill Again

We examine the value of an exploration prospect that is to be exploited via a series of possibly dependent trials. Failure on any particular trial is assumed to convey bad news, but also provides an option to try again. The pattern and strength of dependence among trials determines the value of this option, and therefore also influences the value of the underlying prospect. We describe the solution to this valuation problem, examine the behavior of the option premium, and characterize potential errors that are inherent in two ad hoc procedures that are often used to estimate prospect value. We demonstrate that the impact of dependence among trials is monotonic: each increase in the degree of dependence results in a further reduction in expected value of the prospect. We also characterize the particular pattern of dependence that is implied by a plausible model of exploratory risk.

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

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

Keywords: Oil exploration, valuation, risk, uncertainty, drilling, oil fields

DOI: 10.5547/ISSN0195-6574-EJ-Vol26-No4-4

Published in Volume 26, Number 4 of The Quarterly Journal of the IAEE's Energy Economics Education Foundation.