Option Valuation of Claims on Real Assets Assignment Sample

Application of The Real Options Theory in The Economic Evaluation of An Investment Project in Oil Exploration and Production in Angola

Table of Contents

Chapter 1: Introduction and Overview..

1.1 Brief Introduction of the study.

1.2 Research Problem (Problem Statement)

1.3 Rationale for the study.

1.4 Aims of the study.

1.5 Research Objectives.

1.6 Research Questions.

1.7 Significance of the Research.

1.8 Organization of the rest of the Research (Research Structure)

1.9 Chapter Summary.

Reference.

Chapter 1: Introduction and Overview of Option Valuation of Claims on Real Assets

Chapter 1 of the dissertation will provide an introduction to the thesis, where it aims at providing a brief background to the project. The introduction will also include a review of a significant literature, technical documentation or legislation that will provide contextual framework for the project. It is also going to provide the research approach that is going to be used. 

 1.1 Brief Introduction of The Study

The thesis is going to economically evaluate an oil exploration and production project in the country of Angola by applying the real options theory. Talking about Angola (officially the Republic of Angola), is an African country located on the west-coast of Southern Africa. Angola is an OPEC member and the second largest oil producing country in Africa after Nigeria. During FY 2019, Angola’s oil output remains approx. 1.4 million barrels per day (bpd), along production of natural gas of approx. 17,905 million cubic feet per dat. The oil market witnessed a substantial drop in the prices and since Angolan market had limited foreign reserves, the country could attract minimal investment in both mature and new production and exploration fields between periods from 2014 to 2018. However, fresh announcements related to discoveries and investments in the last year are expected to boost production starting in 2020 and 2021 (OPEC 2020).

From the above brief introduction, it is observed that investments in Angolan oil market are sub-optimal, and therefore we use the Real option theory (ROT) to evaluate and make decisions. ROT is a modern investment theory that is popular in global business schools as a theme and across the boardroom of oil companies. The theory assumes that decision making is sequential process and there are possibilities that benefits can be generated from choosing an option that today look sub-optimal but is capable of increasing flexibility in later periods (The World Bank 2020).

1.2 Research Problem (Problem Statement)

The issue taken into account for the study is the viability of an investment project in oil exploration and production in Angola. Now since traditional capital budgeting or appraisal methods might not be able to provide adequate results about whether to make investments in the Angolan oil market which seems to be sub-optimal in current economic scenarios due to various factors (as will be discussed in the study), the study will put the real option theory into use to conduct a project appraisal and evaluation analysis to not only determine that whether investment in Angolan Oil Market will be beneficial or not, but also identify the timing or sequence of making investments. Also it will tell that if investments are not viable currently then what the future possibilities are. That means, there will be a detailed analysis of the effects of real option theory on the project appraisal study in the Angolan oil market and it will be able to provide information on factors involved in the development process and methods by which employee tracking can affect performances (Aziz et al. 2017).

The theory of real options (or ROT) was first introduced by Paddock, Siegel and Smith, (1988) in the oil and petroleum industry. Their initial research which was based the options theory was aimed at evaluating an offshore lease’s value and the investment timing for its development. The approach of these researchers becomes the most popular model based on real options theory for oil market and petroleum applications. The ROT theory developed as an extension of the financial option theory which simply says that a project or proposal is an option and the business or investor has the right but not the obligation to accept the project if the traditional methods (like NPV, IRR or Payback) gives a green signal for acceptance. So the financial options theory was developed as a methodology for valuating real asset, offshore petroleum lease (in the case of Paddock, Siegel and Smith), where the researchers combined the techniques of option pricing with an equilibrium model in the petroleum market.

As per Fonseca et al. (2017), the declining oil prices resulted as a primary factor that investments in oil and gas projects have been reduced all around the world, (as with the case with Angola in our research). The researchers analyzes the uncertainties in oil price and their impact on investment decision making for an African based oil production and exploration project by applying the real options analysis (ROA). The research discovered that there should be no investment in the oil industry if uncertainties are taken into account. However, when the researchers added uncertainties into the model like volatility in the oil prices then the results indicated that developing an oil field or investment in oil market has a little chance of success. It was also stated that in the existence of uncertainties, a project is able to generate future value. Overall, the research summarized that larger scale investments is able to maximize the value of the asset.

1.3 Rationale for the Study

The Real Option Theory is applicable to the oil and gas industry with higher success ratio as compared to the traditional methods. The traditional project appraisal methods tends to make under assessment of the project’s value, because they are not able to accommodate the required flexibilities for investment management which the management holds and can apply at any time during the project life. On the other hand, the Real Option Theory is able to prevent the under assessment of the project values as it can reduce the market or technical uncertainties using the managerial flexibilities (Li, Reader and Van Schaik 2018).

Every oil and gas project which is going to be explored in Indonesia must have a well-planned for its development this kind of plan is commonly known as Plan of Development (POD). POD contains a deep evaluation from an integrated process including geological and geophysical analysis, study of drilling and production, reservoir management, reservoir simulation in reference to the development scenarios, and financial analysis. The financial analysis of a POD project includes evaluation of each investment scenario that may be applied, and it is made to obtain the maximum income or revenue with the consideration of market and technical condition.

Angola (officially the Republic of Angola), is an African country located on the west-coast of Southern Africa. Angola is an OPEC member and the second largest oil producing country in Africa after Nigeria. During FY 2019, Angola’s oil output remains approx. 1.4 million barrels per day (bpd), along production of natural gas of approx. 17,905 million cubic feet per dat. The oil market witnessed a substantial drop in the prices and since Angolan market had limited foreign reserves, the country could attract minimal investment in both mature and new production and exploration fields between periods from 2014 to 2018. However, fresh announcements related to discoveries and investments in the last year are expected to boost production starting in 2020 and 2021(Taleb 2019).

It is observed from the above discussion that investments in Angolan oil market appear to be sub-optimal, and therefore we use the Real option theory (ROT) to evaluate and make decisions. ROT is a modern investment theory that is popular in global business schools as a theme and across the boardroom of oil companies. The theory assumes that decision making is sequential process and there are possibilities that benefits can be generated from choosing an option that today look sub-optimal but is capable of increasing flexibility in later periods.

Under the real options theory, there are various real options that are available to be modeled as puts and / or calls or their combinations. In the oil or gas or petroleum exploration or production projects, the real option to develop an exploration site is very much similar with that of a call option, where the investor (the producer in the case of oil exploration) has the option to make investment in the development costs and later receive the value out of the reserves in future periods, but he has no obligation to start digging the wells immediately but he can defer the period and the model will also tell about the most appropriate time to start the development by considering variations like oil price volatility into account (Sabet, Agha and Heaney 2018).

The real option theory provides the producer with an alternative option in which he will be able to sell or abandon the property, this is a case where the producer has the right to sell the property and looks very much similar with that of a put option. However, sale of a property is different from selling a financial security or an equity stock put as the producer might not know the price of the sale, unlike the stock-option put, where the exercise price is usually known with certainty (Aziz et al. 2017). This two discussed options are the most basic methods and a producer is availed with a number of various other types of real options strategies. Some of the real options are listed below:

• The option to defer investment
• The option to expand and the option to contract
• The option to default during staged construction
• The option to restart and shut down operations
• The option to discard the project for salvage value
• The option to switch use
• The option of corporate growth

1.4 Aims of the Study

This study aim is to analyze the application of real options theory as an instrument in the economic evaluation of an investment project in oil and exploration and production in Angola.

1.5 Research Objectives

1. To verify the advantages and disadvantages of the real options theory in comparison to traditional investment methods.
2. To evaluate the use of real options theory in Angola’s oil project case study and compare its results with the results of traditional methods.
3. To appraise the limitations and the main difficulties of real options theory method and its applicability in the evaluation of investment projects in the oil exploration and production segment.

1.6 Research Questions

1. What are the advantages and disadvantages of the real options theory in comparison to the traditional investment valuation methods?
2. Under what circumstances is the use of conventional methods most inappropriate?
3. What are the limitations and the main difficulties faced when using the real options theory as a valuation methodology of investment projects?

1.7 Significance of the Research

The practical investigation, which has been conducted while addressing the research questions (as stated above) includes collection and mining of a wide range of information and data related to

1. The oil market
   1. The global oil market
   2. The oil share of OPEC countries
   3. The Angolan economy as a whole
   4. The Angolan oil Market
2. The Theory of Real Options (ROT)
   1. The drawbacks of traditional appraisal theories
   2. The benefits of ROT
   3. Utilization of ROT in the oil and petroleum industry

In order to collect all such information, various books and journal articles have been accessed using database like Google Scholar. The collected sources are then selected based on criteria of authenticity and quality of content and whether these sources are providing adequate knowledge on ways by which the real options theory can be implemented on an appraisal of a project related to Angolan oil market. Apart from this, various authentic websites to gather real-time oil industries information has been accessed online (Fonseca et al. 2017).

1.8 Organization of the Rest of The Research (Research Structure)

The research outline deals with presenting the structure based on which the study has been conducted. The structure has been presented in details as follows:

Chapter 1: Introduction and Overview

This chapter is going to provide briefed information on the rationale and background for conducting the research or study. It will also provide the aim, questions, and objectives of the research on the basis of which the study is going to be conducted.

Chapter 2: Literature Review

This chapter will present the details on various ideas and concepts involved in the use of the Real option theory (ROT) to evaluate and make decisions about investments in Angolan oil market. This chapter will present the reviews of the literature published by intellectuals and experts of oil market and economics.

Chapter 3: Methodology

This chapter will provide important information about the methods that will be used while conducting the research for the study. These methods include designs, data collection and philosophies that will be used for the research.

Chapter 4: Data Analysis and Findings

This chapter of the dissertation is the lynchpin of the study as in this portion, the analysis of the data that has been collected on Angolan oil market, the real option theory (ROT) and what can be the investment decision, will be conducted. It will also provide suggestions about how the real option theory can be applied on the investment appraisal decisions and how this theory is different from the traditional appraisal theories and methodologies. Apart from that, this chapter will also provide the performance tracking information. 

Chapter 5: Conclusion and Recommendations

This will be the final chapter of the dissertation and will summarize and conclude the study on the basis of information collected, perceptions and presumptions taken and the analysis and evaluation of required factors in the study. At the end, this chapter is going to provide the outcome of the study in the form of recommendation, as to whether to make investments in the Angolan oil market, when to make investment and what can be the level of investment.

1.9 Chapter Summary

This study has been conducted to economically evaluate a project of oil exploration and production in the Angolan Oil Market by applying the modern investment appraisal technique of real options theory (ROT). Angola is an OPEC member and the second largest oil producing African country, but due to falling oil prices limited foreign reserves, the Angolan oil market seems to be sub-optimal, and therefore the Real option theory (ROT) has been used to evaluate and make decisions about whether to make investment or not (Aziz et al. 2017). Since, ROT is a modern investment theory which enables the business to make decisions sequentially, unlike traditional methods (like NPV and IRR), hence it has become popular in global business schools themes and is heavily used by oil exploration companies during decision making process. The theory assumes that decision making is sequential process and there are possibilities that benefits can be generated from choosing an option that today look sub-optimal but is capable of increasing flexibility in later periods (Li, Reader and Van Schaik 2018).

Reference for Option Valuation of Claims on Real Assets

Aziz, P.A., Ariadji, T., Fitra, U.R. and Grion, N., 2017. The Implementation of Real Options Theory for Economic Evaluation in Oil and Gas Field Project: Case Studies in Indonesia. International Journal of Applied Engineering Research, 12(24), pp.15759-15771.

Fonseca, M.N., de Oliveira Pamplona, E., de Mello Valerio, V.E., Aquila, G., Rocha, L.C.S. and Junior, P.R., 2017. Oil price volatility: A real option valuation approach in an African oil field. Journal of Petroleum Science and Engineering, 150, pp.297-304.

Li, Y., Reader, S. And Van Schaik, D.L., 2018. Understanding Overseas Investment Choices Made by Chinese NOCs: Case Studies of Sudan, Angola and Nigeria.

OPEC. 2020. Angola facts and figures. https://www.opec.org/opec_web/en/about_us/147.htm

Paddock, J. L., Siegel, D. R., & Smith, J. L. (1988). Option Valuation of Claims on Real Assets: The Case of Offshore Petroleum Leases. The Quarterly Journal of Economics Vol. 103, No. 3, 479-508.

Privacy Shield Framework. 2020. Angola - Oil and Gas. https://www.privacyshield.gov/article?id=Angola-Oil-and-Gas#:~:text=The%20oil%20industry%20in%20Angola,comes%20from%20off%2Dshore%20fields.

Sabet, A.H., Agha, M. and Heaney, R., 2018. Value of investment: Evidence from the oil and gas industry. Energy Economics, 70, pp.190-204.

Taleb, L., 2019. Real Option Analysis versus DCF Valuation-An Application to a Tunisian Oilfield. International Business Research, 12(3), pp.17-30.

The World Bank. 2020. The World Bank in Angola. https://www.worldbank.org/en/country/angola/overview

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