Valuation of Real Options in Crude Oil Production

Abstract

Oil producers are going through a hard period. They have a number of real options at their disposal. This paper addresses the valuation of two of them: the option to delay investment and the option to abandon a producing field. A prerequisite for this is to determine the value of a producing well. For this purpose we draw on a stochastic model of oil price with three risk factors: spot price, long-term price, and spot price volatility. This model is estimated with spot and futures West Texas Intermediate (WTI) oil prices. The numerical estimates of the underlying parameters allow calculate the value of a producing well over a fixed time horizon. We delineate the optimal boundary that separates the investment region from the wait region in the spot price/unit cost space. We similarly draw the boundary governing the optimal exercise of the option to abandon and the one governing the active/inactive production decision when there is no such option.