Offshore exploratory drilling campaigns during oil price downturns: Maximizing value creation from flexibility

During oil price downturns, many operating companies reduce or eliminate large investments with long time horizons such as exploratory drilling campaigns. This reduction in investments induces rig and drilling services providers to decrease their bids to remain competitive. Consequently, the exploration expense is decreased, lessening the initial expenditure in the project. In this research, a valuation approach is implemented to study the impact of this investment reduction on the decision-making process for executing exploratory drilling campaigns during oil price downturns. It is shown that postponing exploration campaigns during oil downturns does not necessary maximize value creation.

Value creation from investment in oil price downturns results from the combination of uncertainty and flexibility. Value of flexibility (optionality), also referred to as Real Options value, can be estimated using a variety of methods. In this work, we use the versatile Least-Square Monte Carlo Method (LSM) approach developed by Longstaff and Schwartz (2001) to evaluate the waiting option for exploration drilling. Uncertainties in oil prices and drilling costs are included as they have the largest impact on the alternative chosen and the value achieved. We implement a two-factor stochastic oil price process developed by Schwartz and Smith (2000), as this model provides a good balance between realism and ease of communication. Uncertainty in the drilling costs is modeled as a Geometric Brownian Motion process. We also account for dependencies between oil price and costs by correlating the drilling cost with the previous period's oil prices.

We show that the real option methodology will identify the optimal time to start exploration drilling. We also demonstrate the effect of correlation between the drilling cost and the oil price on the optimal time to drill; which for this study is the year with lowest expected oil price. Furthermore, we analyze the sensitivity of project value with respect to the correlation factor and the parameters in the stochastic price model. This work demonstrates that including price-cost uncertainties and correlations leads to more realistic value estimates, resulting in investment decisions that maximize value.

This paper contributes to the practice of petroleum project analysis by showing the effect of correlations on the optimal time of drilling and the value of waiting options, demonstrating that it could be optimal to drill exploration wells during oil price downturns. The real option model developed in this paper is applicable to many types of exploration projects in the petroleum industry.