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

Abstract

Exploration for oil and natural gas requires a large investment at the outset to drill an exploratory well that may or may not succeed. If successful, output from the new well will nevertheless typically encompass a broad range of uncertainty. But along with developing exploitable oil or gas reserves, drilling one well can provide valuable information about the potential of further exploration in nearby areas. It may be that the first well is unprofitable, but the information gained in the process leads to profitable development of others nearby. Evaluating an investment in exploration only in terms of net present value without taking account of the information spillover misses what can be a substantial source of value. In this article, van Wijnbergen and Zhao analyze this problem in a real options framework where the value of the optionality gained from drilling an initial well can be properly assessed and integrated into the decisionmaking process.

TOPICS: Options, commodities