The mathematical
insight that allows valuation of options involves the creation of
a portfolio of risk-free debt (i.e. government bonds), the asset
(whether it be a share of stock or an oil and gas project) and an
option on the asset.

By constructing
the portfolio correctly, it can be both risk-free and self-financing.

Once this
is done, the value of an option to acquire the asset (or invest
to develop it) is a function of the uncertainty of the economic
return the asset will generate (which can be estimated) and four
factors that are known:

- The exercise price.
- The risk free rate
of interest.
- The current value
of the asset.
- The time remaining
during which the option can be exercised.

By pricing
the risk (chance) in the project explicitly the method does away
with the need to estimate risk-adjusted discount rates.

The connection
to standard net present value is very simple: If one looks at the
Black-Scholes formula for pricing call options and sets the uncertainty
factor to zero plus the time remaining prior to expiry of the option
to zero, the formula says the option's value is equal to the asset's
value less the exercise price.

In a real
options context this would equate to the net present value being
equal to the present value of future cash flows less the investment
required to realize them.

In simple
terms, when you calculate a net present value you are calculating
an option price assuming no uncertainty in outcome and no time available
to defer investment. Calculating the uncertainty factor is a much
more precise exercise than estimating a risk-adjusted discount rate,
which makes option-pricing the preferred method for analyzing investments
under conditions of uncertainty.

Several
criticisms of the real option approach are mentioned repeatedly:

➤
First, the reasonable comment that, used incorrectly, it is merely
a black box where one can specify some relatively unchallengeable
assumptions of uncertainty and produce a precise (but not accurate)
value for a risky investment.

To be frank, real
option analysis is frequently dismissed as a flaky approach used
to justify higher lease bonuses and inflated acquisition prices
by undisciplined — or worse, unethical — analysts and prospectors.

➤ Second
(and related), specifying option value requires that a company
have the discipline to act when the method requires it.

This means that if
value is predicated in part on the option to abandon a project
at a specific decision point if results fall below a certain expectation,
then abandon you must if all conditions of the analysis prevail.

➤ Third,
most other criticisms flow from a single shortcoming of the method.

The mathematics
underlying the theory is intractable and the insight of the replicating
portfolio approach is not as intuitively satisfying in a real option
context as it is in evaluating financial options where the underlying
asset, usually a share of stock, is freely traded in a public market.

If one
wishes to understand the method there is no real shortcut — although
the math involved in the binomial lattice approach is not that difficult,
and the calculations can be done with a spreadsheet.

Real option
valuation of complex oil and gas investment decisions is not easy,
but it does provide a much better approach to such decisions —
and, when done properly (rather than by some shortcut, cookbook
approach), it actually prevents the kind of over-valuation of risky
investments that it is often accused of enabling.

The true
value of the approach is not that it provides an estimate of the
value of undertaking a specific investment, but rather the discipline
of approaching a complex set of decisions as a series of embedded
options — and developing a strategy to manage the project as uncertainty
resolves.

For those
interested in pursuing the subject further there are several excellent
books that are intended for practitioners rather than financial
theorists. These include:

- Martha Amram and
Nalin Kulatilaka's Real Options: Managing Strategic Investment
In An Uncertain World (Harvard Business School Press, 1999).
- Thomas Copeland and
Vladimir Antikarov's Real Options: A Practitioners Guide (TEXERE,
2001).
- Gordon Sick's Capital
Budgeting with Real Options, Monograph Series in Finance and Economics,
Monograph 1989-3 (Salomon Brothers Center for the Study of Financial
Institutions, Leonard N. Stern School of Business, New York University,
1989)
- Lenos Trigeorgis'
Real Options: Managerial Flexibility and Strategy in Resource
Allocation (MIT Press, 1999)
- "Journal of Applied
Corporate Finance," Volume 13, Number 2 (Summer 2000) & Volume
14, Number 2 (Summer 2001), published by Stern Stewart & Co.
These were special issues devoted to Real Options and both contain
excellent papers on the subject.

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