Real options Analysis in petroleum exploration and production: A new paradigm in investment analysis

More than three decades have passed since Stewart Myers coined the term "real options" and introduced this new paradigm into investment science. In the following years a number of publications in both the finance and decision analysis literature hailed the benefits and power of Real Options for corporate investment decisions. In 2001 Copeland stated that "In ten years, real options will replace NPV (Net Present Value) as the central paradigm for investment decisions.?? Now, eight years hence, the dominating valuation paradigm in the exploration and production industry still seems to be the classical NPV approach. Why? In the time period following the initial applications of real option valuation to oil & gas investments, a number of approaches were proposed for calculating the value of an uncertain investment. Unfortunately, the assumptions underlying these various approaches and the conditions that are appropriate for their application are often not spelled out. Where they are spelled out or can be inferred, they differ widely from approach to approach and are even contradictory. Furthermore, the difficulties in implementing these approaches are rarely discussed and the pros and cons of alternative approaches are not explained. Here we will attempt to help remedy this situation by comparing different real option approaches using a relevant oil & gas investment case. The paper concludes with observations about the relative strengths and weaknesses of the proposed approaches, and offers specific recommendations on which ones to use in what circumstances.