Real Options in Practice: Valuing Connected Gas Fields in the North Sea

Abstract Real option theory has remained a fringe field; practitioners believe it is not practically applicable in complex real world environments. We show that this view is mistaken by applying real option theory to a highly complex energy problem with unhedgeable risk, time varying volatilities and endogenous exercise dates (non-European options). Investment decisions in the energy industry are often undertaken sequentially and are sensitive to information on markets and geographic conditions. Information may arrive gradually over time and as a consequence of early stage decisions. NPV-based frameworks are unsuitable because they do not allow for the fact that new information may change later stage decisions. We apply two real option approaches to exploitation decisions for a cluster of Dutch gas fields, where the two main sources of uncertainty are gas prices and field reservoir size. Gas price returns are modeled with a GARCH specification due to the volatility clustering; while the cost-of-capital or risk tolerance has to be parametrized in face of the incomplete market issue raised by the uncertainty of reservoir size. Moreover investment decisions can be postponed or delayed, which implies an non-European option setting. Least Squares Monte Carlo method is therefore applied for improving the computational efficiency.

Abstract Correctly modeling the structure of volatility has a major impact: Option values shrink by 70% if the time varying nature of volatility is ignored. We also show that a high correlation between reservoir size at different locations creates extra option values. As for the two approaches, option values decrease with the cost-of-capital in use while increase with the investor's risk tolerance. The non-standard features of our approaches result in a major impact: option values are large so real options based valuations substantially exceed corresponding NPV calculations.