What is this paper about?

1. What is this paper about? Use option valuation theory to develop a new approach to valuing leases for offshore petroleum Theoretical and practical problems not present in applying options to financial assets

2. Why is valuation important? • Firms perform valuations as inputs to their bidding process • Government uses to establish presale reservation prices and to study effect of policy changes on revenue (underestimates) • Bidding process involves billions of dollars  important to obtain accurate valuations

3. 3 Stages • Exploration • seismic and drilling activity • quantities of hydrocarbon reserves • costs of bringing them out • Development • put equipment in place to extract oil • platforms, production wells • converts undeveloped reserves to developed • Extraction • Use the installed capacity to take the hydrocarbons out of the ground

4. YES NO OPTION #1 YES NO YES NO OPTION #2 Relinquish? Exploration Results favorable? Relinquish? Extraction Development

5. DCF Approach • Specify distributions for • Exploration costs, quantities of hydrocarbon reserves, development costs, hydrocarbon prices, and operating costs • An analyst determines whether it is optimal for the firm to explore, develop and extract • Analyst makes assumptions about timing, and rate of extraction • The time path of cash flows determined • Involves multivariate Monte Carlo simulations

6. Major Weaknesses of DCF • The proper timing is not transparent • Different assessments of future statistical distributions by different companies • Choosing correct set of risk-adjusted discount rates is a difficult task • Very complex and costly • The assessments of geological and cost distributions can wary widely

7. Tract Valuation by the Option Valuation Approach Characteristics of the Stages Exploration Development Extraction Valuation Petroleum Reserve Market Equilibrium Valuing Undeveloped Reserves Valuing Unexplored Tracts Exploration and Development Lags Optimal Investment Timing Comparative Statics Comparison of Option Valuation and Discounted Cash Flow Approaches

8. Tract Valuation by the Option Valuation Approach Characteristics of the Stages-Exploration The exploration stage consists of the option to make the exploration expenditures and to receive undeveloped reserves. It’s very similar to a stock option. The main difference is the uncertainties ( the quantities of hydrocarbons ) in the exploration stage.

9. Tract Valuation by the Option Valuation Approach Characteristics of the Stages-Exploration We can represent the exploration stage as the option to spend the exploration cost , and receive the expected value of undeveloped reserves where =random quantity of recoverable hydrocarbons in the tract =per unit development cost, a function of quantity =current value of a unit of developed hydrocarbon reserves =probability distribution over the quantity of hydrocarbons =current per unit value of undeveloped reserves given the current per unit value of a developed reserve and per unit development cost =current date =expiration date

10. Tract Valuation by the Option Valuation Approach Characteristics of the Stages-Development Once exploration has provided an indication of the quantity of hydrocarbons, the leaseholder has the option to pay the development costs and install the productive capacity. Characteristics of the Stages-Extraction The leaseholder has the option to extract the hydrocarbons after he has exercised the development option.

11. Tract Valuation by the Option Valuation Approach Valuation-Petroleum Reserve Market Equilibrium In equilibrium, the expected net payoff from holding a developed reserve must compensate the owner for opportunity cost of investing in that reserve. Assume the rate of return to owner follows the diffusion process where =the number of units of petroleum in a developed reserve =the value of a unit of developed reserve =the instantaneous per unit time net payoff from holding the reserve =the required rate of return to the owner =the instantaneous per unit time standard deviation of the rate of return =an increment to diffusion process

12. Tract Valuation by the Option Valuation Approach Valuation-Petroleum Reserve Market Equilibrium comes from two sources The profits from production The capital gain on holding the remaining petroleum Assume a developed reserve follow an exponential decline Then the net payoff can be written as where the net payoff is over a short interval . is the after-tax Operation profit from selling a unit of petroleum

13. Tract Valuation by the Option Valuation Approach Valuation-Petroleum Reserve Market Equilibrium The process for the value of a producing developed reserve =the payout rate of the producing developed reserve =the expected rate of capital gain

14. Tract Valuation by the Option Valuation Approach Valuation-Petroleum Reserve Market Equilibrium Comparison of Variables Pricing Models of Stock Call Options and Undeveloped Petroleum Reserves

15. Valuing Undeveloped Reserves: What is it & Why do we need it? • Given a tract that has been explored, we find X(V, T-t, D) • Firms need to value reserves to make decisions • It is done before valuing an unexplored tract

16. Current stock price Variance of rate of return Exercise price Time to expiration Riskless rate of interest Dividend Value of developed reserve discounted for developed lag Variance of rate of change of the value of a developed reserve Per unit development cost Relinquishment requirement Riskless rate of interest Net production revenue less depletion Comparison of the valuation with Stock Call Options

17. Finding X(V, T-t, D) • Invoke standard arbitrage arguments by replicating the undeveloped reserve’s payoff by holding a portfolio of developed reserves and riskless bonds. • Holding nonproducing developed reserves - feasible but inefficient • Holding producing developed reserves - works

18. Problem • We use the Black-Scholes price as the price of the call option • The price of the contingent claim should equal the cost of a strategy that replicates the returns of that claim • But the option would earn a subnormal rate of return – not an equilibrium situation • Excess of writers to buyers – drives down call price

19. The second one works • The holder of a producing developed reserve earns a fair rate of return • The payout is identical to a proportional dividend on a stock • The PDE for valuing the option on stock can be used for valuing an undeveloped reserve

20. Invoking standard arbitrage arguments • It is difficult to effect the actual arbitrage • We use an equilibrium analysis given by Constantinides [1978] • The equilibrium model of the petroleum reserves in brought in through 

21. Boundary conditions • X(Vt, T-t, D) = Vt – D if Ct = Ct* and Cs<Cs* for all s<t • Ct = Vt / D • Ct* Boundary that maximizes solution • Ct hits Ct* from below for the first time • Ct* can be used for any lease since it is independent of V and D

22. Ct* - a closer look • Hitting boundary decreases with time • Option value decreases with time • No time no option value • Vt - D is not positive anymore

23. Boundary Conditions • X(0,T-t,D) = 0 for all t • If there is no value for the developed hydrocarbon reserve then there is no value for the undeveloped reserve • X(VT, 0, D) = max[0, VT – D] if Cs < Cs* for every s < T • There are no closed forms for the solution to the PDE and Ct* • Use numerical solutions

24. Valuing Unexplored Tracts • Complications due to the properties of the development option and optimal development timing • Assume that development begins immediately after successful exploration – collapse the two options • More later…

25. Finding W(V, T-t, S) • From the development option, we have • Recall, • In an exploration option, you pay and get • Or paying and getting • Value of unexplored tract is

26. The collapsing technique • With no geological uncertainty, S > D if V/S exceeds hitting boundary then so will V/D • With geological uncertainty this is not the case • We get a lower bound to the true option value

27. Exploration and Development lags • Let t be the length of the lag • The value of the claim at t to receive a developed reserve at t+t is • By beginning development at t, the firm gets this claim • The underlying asset in both these options is the claim • Also, Vt follows a diffusion process • We replace Vt with Vt ^ ^

28. Optimal Investment Timing • Begin development or exploration the first time that Ct hits Ct* from below • Insights: • Reserves with low investment costs will hit the boundary before those with high investment costs – Herfindahl’s equilibrium • Properties with shorter investment lags will be explored or developed before those with longer lags

29. Comparison of OV and DCF approaches • Reduces the amount of information required • Estimation of future developed reserve values • Determination of risk-adjusted discount rates • Explicit modeling of the extraction stage

30. Data Sources For Results • Calculate the market value for offshore petroleum tracts awarded to industry in federal lease sale no. 62 in November 18, 1980 • 21 of the 38 tracks compared (available data) • Data on the tracts they used is protected by privacy laws • Paper only looks at bonus bidding with a fixed 16 2/3% royalty on the tracks • Used for tracts valued at <= $10,812,077 • Company owes 16 2/3% in amount or value of production saved, removed or sold

31. Who Benefits? • Relatively low royalty system used since the OCS Lands Act in 1953 • Negative- results in greater risks to the lessee from finding a dry hole • Positive- more rewards (lower contingency payments to the government) if a commercial field is discovered. • If a dry hole is found, then the tract is unusable and the company loses money • If a commercial field is discovered • the company reaps the benefits for the first year • the next year the government recategorizes the tract

32. Calculating royalty on large tracts eg. sliding scale royalty • higher royalty rates for larger reservoirs with higher production rates Rj= b[ln(Vj/s)] (in Millions) Rj is percent royalty due in quarter j b= 13.0 Vj is the value of production in quarter j

33. USGS • Information obtained by USGS for tracks • Mean and variance for quantities of recoverable • oil reserves • condensate reserves • gas reserves • Probability that the tract is dry • Expected • exploration cost • development cost • USGS estimate of tract value (estimated using DCF calculation with the above as input parameters)

34. Inputs into Valuation Equation: Developed reserve value • Compare with current market value • $12/barrel of oil • 1/6 cost of a barrel of oil for an mcf of gas • $2/mcf as benchmark • $3/mcf from private bakers for latter 1980s • Unavailable information to authors would be available to firms: break down the valuation based on the quality of the tract based on market value • Hydrocarbon quality • Cost structure • Tax regime

35. Inputs into Valuation Equation: Variance • Variance of the rate of change in the value of developed reserves • Techniques • Estimate based on past data on market values of developed reserves • Neg: market value data is not publicly available regularly enough to estimate the variance directly • Estimate based on Gruy et al. [1982]: developed reserve prices tend to be 1/3 of crude oil prices • Therefore, use the variance of the rate of change of crude oil prices as a proxy for the variance of the rate of change of developed reserve prices

36. Inputs into Valuation Equation: Variance (cont.) • Representative period: 1974-1980 • Periods of crisis • Periods of tranquility • Using monthly data from 1974-1980: 2=0.02019 -> =0.142 To account for increase in perceived uncertainty: (Jacoby and Paddock[1983]) 2=0.0625 -> =0.250 • Per Barrel Crude oil Wellhead price ranges implicit in standard deviations: Year 0= 1980 @ $36/barrel • 95% confidence

38. Inputs into Valuation Equation: Expected Stages 1&2 Costs • Expected exploration costs before tax (USGS) • 10% of the costs are depreciated (not taxable) Dj=Aj[6Qoj+Qgj] Qoj = recoverable oil reserves on jth tract Qgj = recoverable gas reserves on jth tractAj= tract-specific scaling parameter that considers water depth and drilling depth= 2/3 (Mansvelt Beck and Wiig [1977]) [ ] represent total reserve volume measured in terms of cubic feet of gas equivalent (BTU conversion factor: 1 barrel = 6 mcf)

39. Inputs into Valuation Equation: Expected Stages 1&2 Costs Calculating the track-specific parameters Aj using a fitting procedure. Step 1: Take second-order Taylor Expansion of Dj = variances of oil quantities = variances of gas quantities = covariance between the above two Note: bars represent expected values (which can’t keep) Step 2: Arbitrary assumption: ogi= 0.5 oj oj Solve for Aj to get: Use the track specific means for distributions Dj, Qoj, Qgj Result: Track-specific development cost functions to approximate the true developtment cost functions (information is protected by USGS)

40. Option Valuation Comparisons • Comparison with USGS Estimates • Differences should be due primarily to differences in the financial valuation techniques • To increase the fairness of the comparisons, we assign a zero to the tracts • Other analysts might derive different DCF values using the same geological and cost data

41. Option Valuation Comparisons • Comparison with Industry Bids • The cost and geological data used by the USGS may deviate from industry expectations • Even if the underlying USGS data match industry expectations, we still do not observer industry valuations directly

42. Option Valuation Comparisons • Result • Compare between option valuation, USGS and industry bid values • OV – option valuation • USGS – USGS DCF valuation • GB – Geometric mean of industry bids • HG – High (winning) industry bid

45. Comparative Statics • Variance • Given that oil and gas have been found, there is little likelihood that exploration and development will not occur immediately • Relinquishment requirement • Both of them do not have much effect in the data set. But they would affect tract value in areas subject to higher unit investment cost

47. Exploration and Development Timing • Low-cost tracts should be explored or developed immediately • High-cost tracts should be held from exploration or development • The firm need only calculate C = V/D to decide whether a tract should be explored or developed immediately