W8.0_YPS_REAL OPTION ANALYSIS

Step 1- Problem or Opportunity Statement-

An oil & gas company just acquired an exploration block with negative NPV. The Executive Management asked whether company should exit form that exploration block now or not. Project NCF shown in figure 1.

Figure 1. Project Net Cash Flow (NCF)

Step 2- Develop Feasible Alternatives

The recommendation to the executive management question depends on block value. There are 2 alternatives to calculate that block’s value include Discounted Cash Flow (DCF) Method and Real Option Method.

Step 3- Develop the outcomes for each alternative (minimum 2)

In 1st method, value is calculated as shown in figure 2.

Figure 2. DCF Method

In 2nd method, value is calculated based on 3 options as shown in figure 3 by using Super Lattice Solver as an aid tool.

Figure 3. Strategy Tree

Figure 4. Input in SLS software

Option’s value is calculated through formula as shown in the following equation:

where:

N(x) : the cumulative probability distribution function for a standardized normal distribution.
S0 : stock price at time zero
K : strike price (sometimes strike price is typed as X)
r : risk free rate

Step 4- The acceptable criteria.

In this case study, criteria will be used to select the best alternative is method provide flexibility in decision making to the executive management.

Step 5- Compare the outcomes

In 1st method, DCF provides value of negative US$ 126.70 million. Respect to value from DCF, DCF method provides only one decision which exit from the block.

In 2nd method, Real Option provides value of USD 110.87 million. Respect to value from Real Option method, Real Option provides multiple decisions regard to block value.

Figure 5. Real Option (Lattice 0 – 14)

Figure 6. Real Option (Lattice 15 – 27)

Step 6- Select best alternative.

Regard to step 4 & 5 above, Real Option is chosen because it provides more flexibility in decision making to executive management rather DCF method. Respect to Real Option, the executive management is recommended to continue the operation until production other than exit from the block now.

Step 7- Reporting on the recommended choice

Real Option Method provides more flexibility in decision making process to executive management. In contrary, DCF provides underestimated value and provides single decision.

8 – REFERENCES.

Sullivan, William G., Wick, Elin M., Koelling, C. Patric. (2012). Engineering Economy, Fifteenth Edition, Prentice Hall.

Mun, Johnathan. (2006). Real Options Analysis: Tools and Techniques for Valuing Strategic Investments and Decisions, Second Edition, John Wiley & Sons, Inc.

Hull, John C. (2009). Options, Futures and Other Derivatives, Seventh Edition, Pearson Prentice Hall.