1. A Step-by-Step Approach to Improving Investment Decisions and Asset Valuation Real Options in Exploration & Production of Petroleum By: Marco Antônio Guimarães Dias Petrobras, Brazil Real Option Valuation  (ROV  ) Conference Maximize Return & Minimize Risk in Strategic Investments New Orleans, March 21, 2000

2. Main Real Options and Examples u Option to Delay (Timing Option) l Wait, see, learn before invest l Oilfield development; Wildcat drilling u Abandonment Option l Managers are not obligated to continue a business plan if it becomes unprofitable l Sequential appraisal program can be abandoned earlier if information generated is not favorable u Option to Expand the Production l Depending of market scenario and the petroleum reservoir behavior, new wells can be added to the production system

3.  Tract (lease): Option to Explore (wildcat)  Developed Reserves: Options of Expanding, Temporary Stopping, and Abandonment.  Delineated but Undeveloped Reserves: Option to Develop ( to Produce )  Undelineated Field: Option to Appraise Development Investment Appraisal Investment WildcatInvestment Oil/Gas Success Probability = p Expected Volume of Reserves = B Revised Volume = B’ Options in Exploration & Production (E&P)

4. Types of Uncertainties in E&P u Exploration & Production of petroleum is subject to all types of uncertainties. For investment decisions and valuation purposes, the main types of uncertainty are: l Technical Uncertainty: about the existence, the size, and the economic quality of the reserves. ç E&P technology in ultra deppwaters is another example. ç This uncertainty is solved by a step-by-step investment: sequential real options with option to abandon l Economic/Market Uncertainty: about prices and costs ç Oil prices oscillations: are mean-reverting with jumps? ç Market volatility incentives to wait until the project to become “deep-in-the money”: optimal exercise of the option l Strategic Uncertainty: on the other firms behavior ç Option-Games: drilling games (Dias, 1997); OPEC games

5. Deepwaters Technology: Step-by-Step u New discoveries of large petroleum reserves has been finding in deepwaters and ultra-deepwaters ç Deepwaters is the present and the future in oil exploration u The conquest of deepwaters in offshore Brazil is a good example of the step-by-step approach l In the 80´s, diverless technology reaching 500 meters; l In the 90´s, diverless and guidelineless technology reached 1,853 meters (6,079 ft) (Roncador, 1999); l Petrobras and others are developing technology for up 3,000 meters. Companhies with technology have the option to enter in deepwaters prospects l The technology development for one deepwater oilfield gives a real option to develop other deepwaters oilfields l The technology valuation must consider the real options that it creates, not only the immediate application

6. WATER DEPTH WORLD RECORDS 1977  1999 Deepwaters Technology: A Success History u Most of deepwaters world records occurred in Campos Basin, Brazil

7. Technical Uncertainty u Technical uncertainty decreases as the investment in information is performed (step-by-step approach). u Geological uncertainty is reduced by the investment of the whole industry in a basin l The “cone of uncertainty” (Amram & Kulatilaka) can be adapted to the technical uncertainty understanding: Current project evaluation (t=0) Risk reduction by the investment in information of all firms in the basin (driver is the investment, not directly by the passage of time) Project evaluation with additional information (t = T) Higher Risk Lower Risk Expected Value confidence interval Lack of Knowledge Trunk of Cone

8. Technical Uncertainty u But in addition to the risk reduction process, there is another important issue: revelation of the true value l The expected value after the investment in information can be very different of the initial estimative ç Investment in information reveals good or bad news Current project evaluation (t=0) Investment in Information Project value after investment t = T Value with good revelation Value with bad revelation Value with neutral revelation

9. Technical Uncertainty u The number of possible scenarios to be revealed is proportional to the cumulative investment in information l Information can be costly (our investment) and/or free, from the other firms investment (free-rider). Investment in information (wildcat drilling, etc.) Investment in information (costly and free-rider) Today technical and economic valuation t = 0 t = 1 Possible scenarios after the information arrived during the first year of option term t = T Possible scenarios after the information arrived during the option lease term u The arrival of information process leverage the option value of a tract

10. E&P Process and Options u Drill the wildcat (pioneer)? Wait? Extend? u Revelation: additional waiting incentives Oil/Gas Success Probability = p Expected Volume of Reserves = B Revised Volume = B’ u Appraisal phase: delineation of reserves u Technical uncertainty: sequential options u Delineated but Undeveloped Reserves. u Develop? “Wait and See” for better conditions? Extend the option? u Developed Reserves. u Expand the production? Stop Temporally? Abandon?

11. Valuation of Exploratory Prospect u Suppose the case below: how valuable is this prospect? l Suppose that the firm has 5 years option to drill the wildcat l Other firm wants to buy the rights of the tract. Do you sell? How valuable is the prospect? 20 MM$ (wildcat) 20% success chance 150 MM barrels (expected reserve) Dry Hole “Compact Decision-Tree”

12. Valuation of Exploratory Prospect u The traditional method looks only expected values, forgetting that, in some scenarios (if NPV < 0), rational managers will not exercise the option to develop the petroleum field. u Consider the following data to quantify prospect value: l Petroleum prices: P = 15.1 $/bbl ; l Economic quality of a developed reserve: q = 20% (so one barrel of developed reserve = 0.20 x 15.1 = 3.02 $/bbl); l Total value of the developed reserve V = q.P.B = 3.02 x B (where B is the number of barrels of reserve); l Development cost (D): dividing in fixed (271 MM$) plus variable term (1.1 $/bbl of reserve), hence D = 271 + (1.1 x B) u Using the expected value of reserve volume (B = 150 MM bbl), the value of the prospect by the traditional method is: Net Present Value (NPV) given a discovery: NPV = V  D = q.P.B  D  NPV = (3.02 x 150)  (271 + 1.1 x 150)  NPV = 17 MM US$ l But the chances to discovery petroleum is only of 20% and is necessary to drill the wildcat with cost of E = 20 MM$. So: Expected Monetary Value: EMV =  20 + (20% x 17)  EMV =  16.6 MM US$ (and the prospect is a worthless asset)

13. Prospect with Option to Develop u Considering that rational managers will not exercise the option to develop the petroleum field if it is unprofitable, the prospect value changes a lot. See the table below.  Considering the option, the expected monetary value (EMV) is: EMV =  20 + (20% x 100)  EMV = 0 u Hence, now we are indifferent to drill the wildcat well.

14. Prospect Valuation and Revelation u The previous option analysis consider only uncertainty in the reserve size and the option to develop as a “now- or-never” option (option expiring) l However is not a “now-or-never” option, it is a 5 years option; l In 5 years we shall have many different scenarios due both uncertainties, market (oil prices, costs) and technical (geology) l Revelation of Geology: with the time, the exploratory activity of the whole industry in the basin will reveal good or bad news about the success probability, the productivity of reserve (so, the economic quality of a reserve q), the size of reserves, etc. ç In 5 years several wildcats shall be drilled in the same basin, revealing new values for success chances, reserve productivity and volume, etc. ç You can wait and see the revelation of information (free information) l If you have an option (not an obligation), in 5 years the option will be exercised only if the scenarios combination is favorable.

15. Prospect Valuation under Uncertainty u The table below present the probability distributions at t = 5 years for some uncertain geologic parameters (revelation scenarios) and for one uncertain market parameter (oil prices). Multiplicative Factor for the Reserve Size Distribution ParameterDistributionValues Oil Prices Economic Quality for the Developed Reserve Success Probability for the wildcat well Minimum = 10% Most Likely = 20% Maximum = 30% Minimum = 0.5 Most Likely = 1 Maximum = 1.5 Mean = 15.1 US$/bbl Standard-Deviation = 6 US$/bbl

16. Exploratory Prospect Uncertainty u Considering the uncertainties in oil prices, economic quality of reserve, success probability; and reserve size. l Considering probabilistic distributions but keeping the same expected values (assumptions at t = 5 y. not more optimistic) Without considering the options, the expected monetary value (EMV) @ t = 5 years is negative as before (  16.6 MMUS$)

17. Exploratory Prospect and Revelation u However, @ t = 5 years you will exercise the option only if the NPV is positive. So, the unfavorable scenarios will be pruned (if NPV < 0, set value = zero) l Options asymmetry leverage prospect valuation. EMV = + 14.8

18. Real Options Asymmetry and Valuation + = Prospect Valuation Traditional Value =  16.6 Options Value = + 14.8

19. Prospect Valuation under Uncertainty u However, the value with revelation occurs in the future, @ t = 5 years. Discounting this EMV using a discount rate = 10% p.a., we get: l Present Value of EMV = PV(EMV) = 9.19 MM$ u There is a rent tax to retain the area of concession, but this value is small for exploratory blocks: l Rental = US$ 3,000/year; PV(Rental) = 0.01 MM$ u Hence, the prospect value with revelation is: Value = 9.18 MM$ > > traditional value (  16.6 MM$) u In reality, the correct value is even higher, because is possible that the option becomes “deep-in-the- money” before 5 years l Depending on both market evolution and partial revelation of geology, the option can be exercised before t = 5 years

20. Prospect Valuation under Uncertainty u Considering the option feature of real assets, we get a very different result when comparing with the traditional value. u Now is easy to see that higher uncertainty means higher value if you have time and flexibility (options) u Higher geologic uncertainty: non-mature basins l Higher “revelation” potential than mature basins u But in the valuation we consider European option (exercise only @ t = 5 years). This is a lower bound for the true option value. u Considering an American option (option can be exercise earlier), this value is even higher: l Correct PV(EMV) > + 9.18 MM $

21. E&P Process and Options u Drill the wildcat (pioneer)? Wait? Extend? u Revelation: additional waiting incentives Oil/Gas Success Probability = p Expected Volume of Reserves = B Revised Volume = B’ u Appraisal phase: delineation of reserves u Technical uncertainty: sequential options u Delineated but Undeveloped Reserves. u Develop? “Wait and See” for better conditions? Extend the option? u Developed Reserves. u Expand the production? Stop Temporally? Abandon?

22. Sequential Options (Dias, 1997)  Traditional method, looking only expected values, undervaluate the prospect (EMV =  5 MM US$): l There are sequential options, not sequential obligations; l There are uncertainties, not a single scenario. ( Wildcat Investment ) ( Developed Reserves Value ) ( Appraisal Investment: 3 wells ) ( Development Investment ) Note: in million US$ “Compact Decision-Tree” EMV =  15 + [20% x (400  50  300)]  EMV =  5 MM$

23. Sequential Options and Uncertainty u Suppose that each appraisal well reveal 2 scenarios (good and bad news) èdevelopment option will not be exercised by rational managers èoption to continue the appraisal phase will not be exercised by rational managers

24. Option to Abandon the Project u Assume it is a “now or never” option u If we get continuous bad news, is better to stop investment u Sequential options turns the EMV to a positive value u The EMV gain is  3.25  5) = $ 8.25 being: (Values in millions) $ 2.25 stopping development $ 6 stopping appraisal $ 8.25 total EMV gain

25. E&P Process and Options u Drill the pioneer? Wait? Extend? u Revelation, option-game: waiting incentives Oil/Gas Success Probability = p Expected Volume of Reserves = B Revised Volume = B’ u Appraisal phase: delineation of reserves u Technical uncertainty: sequential options u Delineated but Undeveloped Reserves u Develop? “Wait and See” for better conditions? Extend the option? u Developed Reserves. u Expand the production? Stop Temporally? Abandon?

26. The Extendible Maturity Feature T 2 : Second Expiration t = 0 to T 1 : First Period T 1 : First Expiration T 1 to T 2 : Second Period [Develop Now] or [Wait and See] [Develop Now] or [Extend (pay K)] or [Give-up (Return to Government)] T I M E PeriodAvailable Options [Develop Now] or [Wait and See] [Develop Now] or [Give-up (Return to Government)]

27. Extendible Options: Dias & Rocha (1998/9) u Options with extendible maturities was studied by Longstaff (1990) for financial applications u We (Dias & Rocha, 1998/9) apply the extendible options framework for petroleum concessions. l The extendible feature occurs in Brazil, Europe, USA l Base case of 5 years plus 3 years by paying a fee K (taxes and/or additional exploratory work). l Included into model: benefit recovered from the fee K ç Part of the extension fee can be used as benefit (reducing the development investment for the second period, D 2 ) u We consider both stochastic processes for oil prices, the traditional geometric Brownian motion and the more realistic mean-reversion process with jumps

28. Extendible Option Payoff at the First Expiration u At the first expiration (T 1 ), the firm can develop the field, or extend the option, or give-up/back to govern u For geometric Brownian motion, the payoff at T 1 is:

29. Nominal Prices for Brent and Similar Oils (1970-1999) u We see oil prices jumps in both directions, depending of the kind of abnormal news: jumps-up in 1973/4, 1978/9, 1990, 1999; and jumps-down in 1986, 1991, 1997 Jumps-up Jumps-down

30. Poisson-Gaussian Stochastic Process u We adapt the Merton (1976) jump-diffusion idea for the oil prices case, considering: l Normal news cause only marginal adjustment in oil prices, modeled with a continuous-time process l Abnormal rare news (war, OPEC surprises,...) cause abnormal adjustment (jumps) in petroleum prices, modeled with a discrete time Poisson process u Differences between our model and Merton model: l Continuous time process: mean-reversion instead the geometric Brownian motion (more logic for oil prices) l Uncertainty on the jumps size: two truncated normal distributions instead the lognormal distribution l Extendible American option instead European vanilla l Jumps can be systematic instead non-systematic

31. C++ Software Interface: The Main Window u Software solves extendible options for 3 different stochastic processes and two methods (dynamic programming and contingent claims)

32. The Options and Payoffs for Both Periods T I M E Options Charts T 2 : Second Expiration t = 0 to T 1 : First Period T 1 : First Expiration T 1 to T 2 : Second Period Period

33. Real Applications of this Model u A similar stochastic process of mean-reversion with jumps was used to equity design (US$ 200 millions) for the Project Finance of Marlim field (deepwaters, Brazil) u The extendible options has been used to analyze the development timing of some projects in Campos Basin u The timing policy was object of a public debate in Brazil, with oil companies wanting a higher timing and this model gave some contribution to this debate: l We defended a longer timing policy compared with the first version of the ANP (Brazilian national petroleum agency) l In April/99, the notable economist and ex-Minister Delfim Netto defended a timing policy for petroleum sector citing our paper conclusions about timing policies to support his view! (Folha de São Paulo, a top Brazilian newspaper)

34. E&P Process and Options u Drill the pioneer? Wait? Extend? u Revelation, option-game: waiting incentives Oil/Gas Success Probability = p Expected Volume of Reserves = B Revised Volume = B’ u Appraisal phase: delineation of reserves u Technical uncertainty: sequential options u Developed Reserves. u Expand the production? Stop Temporally? Abandon? u Delineated but Undeveloped Reserves. u Develop? “Wait and See” for better conditions? Extend the option?

35. Option to Expand the Production u Analyzing a large ultra-deepwater project in Campos Basin, we faced two problems: l Remaining technical uncertainty of reservoirs is still important. In this specific case, the better way to solve the uncertainty is by looking the production profile instead drilling additional appraisal wells l In the preliminary development plan, some wells presented both reservoir risk and small NPV. ç Some wells with small positive NPV (not “deep-in-the- money”) and others even with negative NPV ç Depending of the initial production information, some wells can be not necessary u Solution: leave these wells as optional wells l Small investment to permit a future integration of these wells, depending of the market evolution and the production profile response

36. Modelling the Option to Expand u Define the quantity of wells “deep-in-the-money” to start the basic investment in development u Define the maximum number of optional wells u Define the timing (or the accumulated production) that the reservoir information will be revealed u Define the scenarios (or distributions) of marginal production of each optional well as function of time. l Consider the depletion if we wait after learn about reservoir l Simplify considering yearly distributions and limiting the expiration of the option (declining NPV due the depletion) u Add market uncertainty (reversion + jumps for oil prices) u Combine uncertainties using Monte Carlo simulation u Use optimization method to consider the earlier exercise of the option to drill the wells, and calculate option value l Monte Carlo for American options is a frontier research area

37. Conclusions u Real Options is the new paradigm for economic analysis of assets, projects, and opportunities under uncertainty. l Real options can be viewed as a NPV maximization given the options and given the uncertainties/stochastic processes l Need training, knowledge, and good computers u Valuation of rights/projects using traditional methods underestimates values, resulting on very wrong values. l Implications for petroleum real assets negotiations, bids, etc. l Implications for investment decisions and portfolio selection u Firms need to develop simple and more complex models. l Simple models are important for fast calculations. l Interactive interface, charts, and educational work. l Real world and specific issues demand also more complex and “taylor-made” models: in-house models l Firms need to follow the state of the art and the growing literature