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Petroleum Property Valuation: A Binomial Lattice Implementation of Option Pricing Theory

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  • Eric Pickles
  • James L. Smith

Abstract

We take a simple tutorial approach to explain how option valuation can be applied in practice to the petroleum industry. We discuss a simple spreadsheet formulation, demonstrate how required input data can be extracted from market information, and give several exploration and development examples. Under the market and fiscal conditions described we derive the value of discovered, undeveloped reserves projected to result from offshore licensing in the United Kingdom, and we show how to determine the maximum amount that should be committed to an exploration work program to find those reserves. Lease-bidding and farm-out applications are briefly described. We recommend option valuation as an alternative to discounted cash flow analysis in situations where cash flows are uncertain and management has operating flexibility to adjust investment during the life of the project, and point to further work needed to fully value nested or embedded options.

Suggested Citation

  • Eric Pickles & James L. Smith, 1993. "Petroleum Property Valuation: A Binomial Lattice Implementation of Option Pricing Theory," The Energy Journal, International Association for Energy Economics, vol. 0(Number 2), pages 1-26.
    • Handle: RePEc:aen:journl:1993v14-02-a01
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    Cited by:

    1. Kocagil, Ahmet E. & Eduardo, Benjamin E., 1996. "Impacts of new environmental standards on mining industry: The case of Peru," Resource and Energy Economics, Elsevier, vol. 18(3), pages 291-310, October.
    2. Simone Kelly, 2017. "The market premium for the option to close: evidence from Australian gold mining firms," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 57(2), pages 511-531, June.
    3. Davis, Graham A., 1998. "Estimating Volatility and Dividend Yield When Valuing Real Options to Invest or Abandon," The Quarterly Review of Economics and Finance, Elsevier, vol. 38(3, Part 2), pages 725-754.
    4. Guedes, José & Santos, Pedro, 2016. "Valuing an offshore oil exploration and production project through real options analysis," Energy Economics, Elsevier, vol. 60(C), pages 377-386.
    5. Niall Farrell & Mel T. Devine & William T. Lee & James P. Gleeson & Seán Lyons, 2017. "Specifying An Efficient Renewable Energy Feed-in Tariff," The Energy Journal, , vol. 38(2), pages 53-76, March.
    6. Rodrigo R. de Freitas & Diego M.E. Gonçalves & Thiago de S.C.P. Mayrink & Márcio de A. D’agosto, 2018. "Analysis of ore transportation: A financial approach using the Black & Scholes method in real options," Journal of Finance and Investment Analysis, SCIENPRESS Ltd, vol. 7(4), pages 1-4.
    7. Graham A. Davis & Robert D. Cairns, 1998. "Simple Analytics of Valuing Producing Petroleum Reserves," The Energy Journal, International Association for Energy Economics, vol. 0(Number 4), pages 133-142.
    8. Mahdi Mattar & Charles Cheah, 2006. "Valuing large engineering projects under uncertainty: private risk effects and real options," Construction Management and Economics, Taylor & Francis Journals, vol. 24(8), pages 847-860.
    9. Sunnevag, Kjell, 1998. "An option pricing approach to exploration licensing strategy," Resources Policy, Elsevier, vol. 24(1), pages 25-38, March.
    10. Lander, Diane M. & Pinches, George E., 1998. "Challenges to the Practical Implementation of Modeling and Valuing Real Options," The Quarterly Review of Economics and Finance, Elsevier, vol. 38(3, Part 2), pages 537-567.
    11. Kelly, Simone, 1998. "A Binomial Lattice Approach for Valuing a Mining Property IPO," The Quarterly Review of Economics and Finance, Elsevier, vol. 38(3, Part 2), pages 693-709.
    12. Hemantha Herath & Pranesh Kumar & Amin Amershi, 2013. "Crack spread option pricing with copulas," Journal of Economics and Finance, Springer;Academy of Economics and Finance, vol. 37(1), pages 100-121, January.

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    JEL classification:

    • F0 - International Economics - - General

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