Many of you are looking at groups of undeveloped wells, either yours or someone else’s, and the numbers are telling you that they have a negative value – technically the seller should have to pay to get rid of them. But we all know that’s not the case. They have some value – maybe small, but something. How do you put a number on that value?
Traditional Methods are No Help
Right now, you’re probably using Net Present Value to evaluate those undeveloped properties. There’s nothing inherently wrong with NPV, but it has several weaknesses that just don’t help in today’s price environment.
First and foremost is that most NPVs use one price through the future. Some test with a few different future prices, but all that reveals is the range of exposure – not the likelihood and therefore, not the value. Some will test a range of subsurface outcomes – but not as often. Some will test a range of cost estimates. But rarely. If the NPVs are coming from Aries, or PhdWin, then it’s definitively just averages. Everyone understands that’s inadequate, so there are several techniques to “risk-adjust” the NPVs.
According to the SPEE1, the most common method used to risk adjust the NPV is discount rates. NPVs for projects that are perceived as “riskier” are discounted at a higher rate. This has the effect of making the capital costs, which are usually up-front, appear larger than the revenue, which usually comes later, for many years. However, this doesn’t help in the current situation (or ever, really, but that’s a story for a different essay). It doesn’t matter how you discount, these current wells can’t be profitable. If you drill them now, prices are too low now to support the well. This just can’t reveal the value of that undeveloped project – it can just tell you that it’s not profitable now.
The second most popular method is “scenario” analysis. A few scenarios are run, with different price decks, maybe with different subsurface results. Then someone subjectively approximates the probability that each scenario could occur, the different NPVs are weighted by the risk estimate, and voila! a risk-adjusted NPV results. The biggest problem with this is that we are terrible at estimating the likelihood of anything happening (see Macando), so we end up with a bigger mess than we started with.
At a high level, that sounds an awful lot like a drilling lease – the lease holder has “the right, but not the obligation” to drill on the owner’s land, for a certain period of time. For many years, the financial community struggled with how to price options. It was well understood that it was a probability issue – that prices could wander in the future, and that some of them would result in the option expiring “in the money,” i.e. worth something, and some would not. It wasn’t until the pioneering work of Black and Scholes in the early 70’s that the issue was finally settled.
But it wasn’t. Though the Black-Scholes formula is well-suited to pricing options that can be exercised only at their expiration dates (“European” options), most interesting options are “American” – they can be exercised “on or before a specified date.” (Sounds like a lease again.) Black-Scholes cannot price American options2. There are some valuation practitioners out there who claim to be using Black-Scholes for undeveloped properties. If they are, avoid them.
A whole host of methods have been developed to price more complex options, with exotic names like Binomial Tree, or Monte Carlo Simulation. Their details aren’t really pertinent to this discussion, but they address almost all of the shortcomings of Black-Sholes at pricing complex options – and real petroleum projects.
The applicability of financial option valuation techniques to non-financial projects is not a recent development. The academic literature is rich with papers that explore this concept. A review of these articles reveals that “real” projects differed from financial projects in one significant way – there was flexibility embedded in the real projects, that wasn’t in the financial “projects.” This field was dubbed “real options.”
Every petroleum project has these embedded options that conventional techniques ignore. Drilling can be delayed if the current price environment is unfavorable. (Sound familiar?) The field can be shut-in, or abandoned if unprofitable. If the subsurface results are favorable, the field can be down-spaced (expanded). If they are unfavorable, the entire field abandoned. Conventional techniques just aren’t up to the task of properly valuing any real petroleum project.
The Simulation Approach
Almost every other approach developed to value options came about because the most suitable approach, simulation, was impossible to do in a reasonable period of time . Now that computer power has caught up with simulation needs, simplified methods aren’t required. We understand how to simulate what prices can look like in the future, and simulate the decisions that would be made along the way to drill, or to abandon, etc.
The key is that we don’t forecast prices. Simulation approaches generate many future price paths that move up and down just like real prices do, with random movements. Though in the real world, real events generate those movements, statistically, they look random – and that allows us to simulate them.
Each of those thousands of futures has a value – positive and negative. By averaging the positive values, we can estimate how much (or little) that project’s value is.
Applicability to Petroleum Properties
It should be clear by now that we believe that the techniques pioneered in the financial industry can and should be applied to the oil and gas business. Only with a sophisticated approach can all of the real options be included. Only with a sophisticated approach can biases in price estimates be avoided, allowing the statistics to express themselves in value. Only with a sophisticated approach can the valuation be truly customized for your company’s value proposition.
To answer the question: Yes, they are worth something. But you won’t figure that out with a simple NPV.
- http://comptroller.texas.gov/taxinfo/proptax/pdf/96-1166.pdf ↩
- Geske, Robert, and Richard Roll. “On Valuing American Call Options with the Black‐Scholes European Formula.” The Journal of Finance 39, no. 2 (1984): 443-455. ↩