Title: Investment decision in oil and gas projects using real option and risk tolerance models

Authors: Gabriel A. Costa Lima, Saul B. Suslick

Addresses: Center of Petroleum Studies and Institute of Geosciences, State University of Campinas – Unicamp, P.O. Box 6152, Campinas, SP 13083-970, Brazil. ' Center of Petroleum Studies and Institute of Geosciences, State University of Campinas – Unicamp, P.O. Box 6152, Campinas, SP 13083-970, Brazil

Abstract: This paper presents a model for valuation and decision making, integrating discounted cash flow, real-options pricing and preference theory, aiming to cover the following questions: i) what is the current value of a project?; ii) what is the optimal investment rule?; iii) what is the optimal working interest? The traditional model suggests that, when the project value is above its investment cost, the corporation should invest immediately and incur in 100% working interest. The real option pricing suggests that the corporation should only invest if the project|s current value is at least 1.85 times investment cost. The preference theory suggests funding only 44.38% working interest, and partners must acquire the remaining 55.62%. These tools must be integrated in order to allow a more realistic treatment of risk. In general, when the uncertainty (volatility) of cash flow components increases, the two models give more divergent results.

Keywords: uncertainty; real options; capital budgeting; preference theory; petroleum exploration; production; investment decisions; oil projects; gas projects; risk tolerance; modelling; valuation; decision making; discounted cash flow.

DOI: 10.1504/IJOGCT.2008.016729

International Journal of Oil, Gas and Coal Technology, 2008 Vol.1 No.1/2, pp.3 - 23

Published online: 18 Jan 2008 *

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