Two Factor Oil Price Model

EM162862 DOI: 10.
2118/162862-PA Date: 19-July-12
Stage:
Page: 158
Total Pages: 13
Two-Factor Oil-Price Model and Real

Option Valuation: An Example of Oilfield
Abandonment
B. Jafarizadeh, SPE, and R.B. Bratvold, SPE, University of Stavanger
Summary
We discuss the two-factor oil-price model in valuation and analysis of flexible investment decisions. In particular, we will discuss
the real options formulation of a typical oilfield-abandonment
problem and will apply the least-squares Monte Carlo (LSM) simulation approach for calculation of project value. In this framework, the two-factor oil-price model will go a long way in the
analysis of decisions and value creation. We also propose an
implied method for estimation of parameters and state variables
of the two-factor price process. The method is based on implied
volatility of option on futures, the shape of the forward curve, and
the implicit relationship between model parameters.
Introduction
Over the past several decades, the oil and gas industry has adopted
increasingly sophisticated methods for dealing with the uncertainties and risks embedded in the majority of their investment opportunities (Bickel and Bratvold 2008). It is recognized that a
consistent probabilistic approach provides improved understanding and insights into the range of possible outcomes and their values. Yet, although most oil and gas companies appreciate the
impact of commodity prices on the value of their potential investments, few are implementing price models at the level of probabilistic sophistication and realism of their, say, subsurface models.
Frequently in discounted cash-flow (DCF) valuations, conservative assumptions about the price variables are used to generate information about what value could look like if things
proceed poorly. The resulting corporate planning price is sometimes called the expected price, and the investment is also
valued using a high and a low price.1 This is stress testing, not
valuation. Value is a price and, as such, is a number and not a
distribution.
Numerous oil and gas companies have made extensive use of
decision-analysis methods, and some have also looked with
increasing interest at recent developments in valuing the flexibility inherent in oil and gas investment opportunities. Valuing these
flexibilities requires us to ask and answer some questions we usually do not address in traditional decision analysis. In decisiontree analysis, it is usually sufficient to specify a low, medium, and
high scenario for the uncertain variables. Flexibility value is
derived from being able to respond to uncertainties as they are
being resolved and thus requires a series of conditional probability
distributions. In addition to specifying a probability distribution
for the price (and other uncertain variables) for the current time
period, we need to specify the distribution of prices for next time
period given the current prices. This allows us to determine the
optimal action in any time period, given the states of the underlying uncertainties in the previous year.
Most of the literature on models that try to capture the price
volatility assumes that the price follows a random walk (i.e., to
1
Companies often refer to the low and high price values as the P10 and P90 value, respectively, although, clearly, they are not P10 and P90 values drawn from the underlying
distribution.
consider them as stochastic processes that evolve over time)2

(Laughton and Jacoby 1993, 1995; Cortazar and Schwartz 1994;
Dixit and Pindyck 1994; Pilipovic 1998; Schwartz 1997;
Schwartz and Smith 2000; Geman 2005). Clearly, a requirement
for the chosen stochastic representation to be useful is that it
should be consistent with the dynamics of the hydrocarbon prices
over an observed time period and lead to probability distributions
for the price, St, that agrees with the observations and known
characteristics of that distribution.
In this paper, we illustrate the implementation and calibration
of a two-factor stochastic price model developed by Schwartz and
Smith (2000), hereafter referred to as the SS model.3 This model
allows mean-reversion in short-term price deviations and uncertainty in the long-term equilibrium level to which prices revert. It
provides advantages over more-basic methods, but is still simple
enough to be communicated to corporate decision makers who are
generally not experts in financial modeling or option theory. The
balance between realism and ease of communication of the model
has led us to choose this model in favor of one-factor models, in
which it is assumed that only one source of uncertainty contributes to the uncertainty in prices, or other multifactor models
where two or more factors contribute to the uncertainty in prices
(see Schwartz 1997, Geman 2000, and Cortazar and Schwartz
2003 for two- and three-factor price models).
Schwartz and Smith (2000) used a Kalman filter to estimate the
model parameters and state variables on the basis of historical spot
and futures prices. They also mention the possibility of using implied
estimates from market data about future price levels. Inspired by
this, we illustrate how current market information can be used to
assess the parameters and initial state variables of the SS price
model. As opposed to the Kalman filter technique, the implied
approach to parameter estimation is simple and intuitive, and it will
generate estimates that are sufficient for most valuation assessments.
We will also apply the SS price model to value the abandonment-timing option of an oil-producing field. In principle, the oil
field should be abandoned as soon as the revenues from the field
are less than the costs of producing its oil. However, given the
uncertain nature of both the revenue and cost elements, the decision maker has to continuously evaluate the expected values of either continuing the production or abandoning the field. Modeling
the abandonment-timing decisions as an American-put option and
solving for the general form is complex and cumbersome (Myers
and Majd 1990). Fortunately, more-recent developments in real
options analysis make the value assessment easier and provide valuable decision insight. In this work, we apply the LSM approach
(Longstaff and Schwartz 2001) to value the abandonment-timing
option, where the oil prices follow the SS price process.4 We
2
The fact that commodity prices are unpredictable creates a need for price modeling. In
this paper we do not provide forecasting methods because it is always impossible to correctly forecast the future commodity prices. Instead, we discuss a model that is capable of
appreciating the dynamics of commodity price and can create insight in the process of
investment decision making.
3
Two-factor stochastic price models have also been discussed in other works (Pilipovic
1998; Baker et al. 1998). Pindyck (1999) argues that the oil prices should be modeled using
a stochastic model that reverts toward a stochastically fluctuating trend line.
4
C 2012 Society of Petroleum Engineers

Copyright V
Original SPE manuscript received for review 27 October 2010. Revised manuscript received
for review 17 March 2012. Paper (SPE 162862) peer approved 30 April 2012.
158
Simulation-based valuation of American options using nonparametric regression methods

was initially discussed in Carriere (1996). Longstaff and Schwartz (2001) and Tsitsiklis and
van Roy (1999, 2001) applied the least-squares regression for simulation-based valuation
of American options.
July 2012 SPE Economics & Management

ID: jaganm Time: 17:32 I Path: S:/3B2/EM##/Vol00000/120017/APPFile/SA-EM##120017
EM162862 DOI: 10.2118/162862-PA Date: 19-July-12
GBM - P10
GBM - Mean
GBM - P90
OU - P10
OU - Mean
OU - P90
Oil Price, USD/bbl
160
150
140
130
120
110
100
90
80
0
10
Time, years
Fig. 1Comparison of GBM and mean-reverting (OU) price
processes.
assume further that there is an uncertain abandonment cash flow

that includes both the decommissioning costs and the potential
value of selling or reusing production equipment and can thus be
either negative or positive. We illustrate how the LSM method can
be used to assess the value of the abandonment option and create
insight into the decision. We also discuss some limitation of the
LSM approach to valuation.
The contributions of this paper are three-fold: (1) to familiarize the reader with the SS model and illustrate its use in valuing
the abandonment option, (2) to apply the implied approach using
forward curve and options on futures to estimate the parameters
and state variables of the SS model, and (3) to illustrate how the
LSM approach can generate decision insight for the abandonment-timing problem. The next section introduces relevant stochastic price processes and reviews some key literature. We then
introduce the SS model in The Schwartz and Smith Two-Factor
Price Model and Its Calibration section and illustrate the mechanics on the implied volatility parameter estimation approach. The
Project Valuation section discusses project valuation, including
abandonment-timing decisions, and formulates the abandonment
option. In that section, we also calculate the project value using
the LSM algorithm and use the SS price process for oil prices.
The section concludes with analysis of the results and a discussion
on potentials and weaknesses of the LSM algorithm. In the Conclusions section, we discuss some challenges.
Oil-Price Modeling: An Introduction to Stochastic

Price Models
It is well recognized that hydrocarbon-price uncertainty is one of
the main factors that drive uncertainty in economic value assessments used to make decisions in oil and gas companies. Any valuation methodology used for evaluating investment opportunities
should therefore include a dynamic price modelone that replicates the characteristics of real price fluctuations as a function of
time, not only the mean price. There is a rich literature on oil and
gas price modeling, and much of it has been motivated by the
desire to improve the quality of investment valuation under price
uncertainty.
There have been tremendous changes in the nature of crude-oil
trading over the past 30 years. Whereas major oil companies used
to refine and trade the majority of their produced volumes themselves, the majority of the produced crude is now being traded in
the commodity markets (Geman 2005). Oil is one of the largest
commodity markets in the world, and it has evolved from trading
the physical oil into a sophisticated financial market with derivative trading horizons up to 10 years or more.5 These derivative
5
A derivative can be defined as a financial instrument whose value depends upon (or
derives from) the value of other basic underlying variables. Quite often, the variables underlying derivatives are the prices of traded assets. For example, oil-price futures, forward and
swaps are derivatives whose values are dependent on the traded price of oil. An option on
futures contract is a derivative whose value depends on the value of a futures contract,
which itself is written on oil price.
Stage:
Page: 159
Total Pages: 13
contracts are now dominating the process of world-wide oil-price

developments. One effect of this change is that the crude-oil markets are now liquid, global, and volatile.
The early real options literature assumed that there is a single
source of uncertainty related to the prices of commodities (see
Brennan and Schwartz 1985 or Paddock et al. 1988 for applications of single-factor price models). These studies assumed oil
spot prices followed a geometric-Brownian-motion (GBM) process. The GBM approach to oil-price modeling is based on an analogy with the behavior of prices of stocks in the capital markets.
This price process assumes that the expected prices grow exponentially at a constant rate over time and the variance of the prices
grows with proportion to time. This is the price model underlying
the well-known Black-Scholes options pricing formula.
The GBM price process is, however, not consistent with the
behavior of commodity prices. Historically, when prices are
higher than some long-run mean or equilibrium price level, more
oil is supplied because the producers will have incentives to produce more and prices tend to be driven back down toward the
equilibrium level. Similarly, when prices are lower than the longrun average, less oil is supplied and prices are driven back up.
Therefore, although there may be short-term disequilibriums,
there is a natural mean-reverting characteristic inherent to oil prices. The mean-reverting behavior of oil and gas prices has been
supported in a number of studies, including the comprehensive
works of Pindyck (1999, 2001).6 The mean-reverting price process has been used for price modeling in a number of oil- and gasrelated studies (Laughton and Jacoby 1993, 1995; Cortazar and
Schwartz 1994; Dixit and Pindyck 1994; Smith and McCardle
1999; Dias 2004; Begg and Smit 2007; Willigers and Bratvold
2009).7 The effect of modeling a price process that is actually
mean reverting with a GBM can be a significant overestimation of
uncertainty in the resultant cash flows. This, in turn, can result in
overstated option values. Fig. 1 shows a comparison of GBM and
a mean-reversion process with the same volatility.
As noted by several authors (Dias and Rocha 1999; Dias 2004;
Geman 2005; Begg and Smit 2007), a key characteristic of oil prices is that their volatility appears to consist of normal fluctuations along with a few large jumps. These jumps are associated
with the arrival of surprising or abnormal news. The most
common approach to include such jumps is to combine a meanreverting process with a Poisson process, with the additional
assumption that the two processes are independent.
Although the one-factor model8 can be used to capture mean reversion in the oil price, it assumes that there is no uncertainty in the
long-term equilibrium price. Gibson and Schwartz (1990), Cortazar and Schwartz (1994), Schwartz (1997), Pilipovic (1998), Baker
et al. (1998), Hilliard and Reis (1998), Schwartz and Smith (2000),
Cortazar and Schwartz (2003), and others have introduced composite diffusions that include a second or third factor to model uncertainty explicitly in several of the price parameters. These factors
include short-term deviations from the long-term equilibrium level,
in the equilibrium itself, in the convenience yield,9 or in the
risk-free interest rate. Pindyck (1999) argues that the actual
6
Statistical analysis may be used to investigate whether GBM or mean-reverting processes

best match the historical hydrocarbon prices. The unit root test [developed originally by
Dickey and Fuller (1981)] is particularly useful for such a comparison. However, as pointed
out by Dixit and Pindyck (1994), it usually requires numerous years of data to determine
with any degree of confidence whether a variable (e.g., oil price) is mean reverting. For
example, using approximately 30 years of oil-price/time series fails to reject the GBM hypothesis. Pindyck (1999) rejects the GBM hypothesis only after considering more than 100
years of oil-price data.
7
Uhlenbeck and Ornstein (1930) introduced the first mean-reverting model. This model
has been applied in biology, physics, and other areas of study, and recently in finance,
commodity derivatives pricing, and petroleum valuation, to describe the tendency of a measurement to return toward a mean level.
8
In a price model, a factor represents a market variable that exhibits some form of random
behavior. The GBM and OrnsteinUhlenbeck (OU) models are one-factor models because
only the price is random. In two- and three-factor models, the long-term price, convenience
yield, or interest rate may be modeled as random variables in addition to the price.
9
The convenience yield represents the flow of benefits that accrue to the owner of the oil
being held in storage. These benefits derive from the flexibility that is provided by having
immediate access to the stored oil.

159
- - - Spot Prices
Equilibrium Prices
Oil Price, USD/bbl
Oil Price, USD/bbl
150
140
130
120
110
100
90
80
70
60
50
P90
Expected
Values
P10
10
behavior of real prices over the past century implies that the oilprice models should incorporate mean-reversion to a stochastically
fluctuating trend line. He adds that the theory of depletableresource production and pricing also confirms these findings.
Schwartz (1997) compares three models of commodity prices that
include mean reversion. The first of these three models was a simple one-factor model in which the logarithm of the price is assumed
to follow an OU process (Uhlenbeck and Ornstein 1930). The second and third models were two-factor models. Schwartz (1997)
showed that, in relative performance, the two-factor models outperformed the one-factor model for all the data sets used in the
study. For an additional discussion of stochastic processes for oil
prices in real options applications, see Dias (2004).
The SS Two-Factor Price Model and
Its Calibration
In this section, we illustrate the implementation and calibration of
the two-factor price process proposed by Schwartz and Smith
(2000). This model allows mean reversion in short-term prices
and uncertainty in the long-term equilibrium level to which prices
revert.10 The equilibrium prices are modeled as a Brownian
motion, reflecting expectations of the exhaustion of existing supply, improved exploration and production technology, inflation,
and political and regulatory effects. The short-term deviations
from the equilibrium prices are expected to fade away in time and
therefore are modeled as a mean-reverting process. These deviations reflect the short-term changes in demand, resulting from
intermittent supply disruptions, and are smoothed by the ability of
market participants to adjust the inventory levels in response to
market conditions.
The SS Model. Allow St be the commodity price at Time t, then
lnSt nt vt ; . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
where nt is the long-term equilibrium price level and vt is the
short-term deviation from the equilibrium prices. The long-term
factor is modeled as a Brownian motion with drift rate ln and volatility rn.
dvt jvt dt rv dzv ; . . . . . . . . . . . . . . . . . . . . . . . 3
10
The convenience yield is implicit in the SS model as opposed to the Gibson and
Schwartz model, where it is modeled explicitly.
11
The mean-reversion coefficient j describes the rate at which the short-term deviations
are expected to disappear. Using j, we can calculate the half-life of the deviations, [ln(2)]/
j, which is the time in which a deviation in v is expected to halve.
160
Page: 160
Total Pages: 13
- - - Spot Price
- - - Risk-Neutral Price
P90
Expected
Values
P10
10
Time, years
Fig. 3Confidence bands for the spot and risk-neutral price
processes.
where dzv and dzn are correlated increments of standard Brownian-motion processes with dzndzv qnvdt. It can be shown that the
model includes the GBM and geometric OU models as special
cases when there is uncertainty only in either the long-term or
short-term prices, respectively.
Fig. 2 shows the P10 and P90 confidence bands and the
expected values for oil prices generated by the two-factor process
conditional on an initial price of USD 99/bbl and market information observed on 15 May 2011. These confidence bands show that
at a specific time there is a 10% and 90% chance (respectively)
that the prices fall below that amount.
Fig. 2 shows that the expected spot and equilibrium prices will
be equal after a few years. This is caused by the fact that short-term
fluctuations are expected to fade away after a few years and the
only uncertainty in the spot prices would be because of the uncertainty in the equilibrium prices. This phenomenon is also consistent
with the observations in the commodity markets. In these markets,
the volatility of the near-maturity futures contracts is significantly
higher than the volatility of far-maturity futures contracts and the
trend implies that as maturity of the futures contracts increase, the
volatility decreases. If we think of oil prices in terms of the twofactor price model, then we can conclude that the volatility of the
near-maturity futures contracts is given by the volatility of the sum
of the short-term and long-term factors. As the maturity of the
futures contracts increases, the volatility approaches the volatility
of the equilibrium price (Schwartz and Smith 2000).
Risk-Neutral Version of the SS Process. We will calculate the
project value with abandonment option using the risk-neutral valuation scheme (to be discussed in more detail in the Project Valuation section) and will thus need the risk-neutral process to
describe the dynamics of the oil prices. The implied parameterestimation method is based on the use of futures contracts and
options on these futures, which are valued using the risk-neutral
processes. In this framework, all cash flows are calculated using
the risk-neutral processes and discounted at a risk-free rate. The
short-term and long-term factors in the risk-neutral version of the
two-factor price process are described by the following equations:
dvt jvt kv dt rv dzv : . . . . . . . . . . . . . . . . . . 4
dnt ln dt rn dzn : . . . . . . . . . . . . . . . . . . . . . . . . . 2
The short-term factor is modeled with a mean-reverting process with mean-reversion coefficient j11 and volatility rv.
150
140
130
120
110
100
90
80
70
60
50
0
Time, years
Fig. 2Confidence bands for the real stochastic process used
for modeling oil prices.
Stage:
dnt ln kn dt rn dzn ; . . . . . . . . . . . . . . . . . . . . 5
where, as before, dzn and dzv are correlated increments of the
standard Brownian motion such that dzn dzv qnv dt and where
kv and kn are risk premiums that are being subtracted from the
drifts of each process.12 The risk-neutral short-term factor is now
reverting to kv =j instead of zero as in the real process. The drift
of the long-term factor in this model is ln ln kn . Fig. 3
12
The risk premium is the amount that the buyer or seller of the future contract is willing to
pay in order to avoid the risk of price fluctuations. We use the standard assumption of constant market prices of risk (Schwartz 1994).

compares the P10/P90 confidence bands of the spot prices and the
risk-neutral prices.
Model Calibration. In the SS model, the commodity prices are
mean reverting toward a stochastically fluctuating equilibrium
level. This model has a total of seven parameters (j, rv, ln, rn,
qvn, kv, and kn);13 along with two initial conditions v0 and n0 to
be estimated. The model parameters are not observable in the
commodity markets, and a standard nonlinear least-squares optimization cannot be applied directly. In the absence of observed
parameters, one possible approach would be to estimate the parameters using the Kalman filter14 (Schwartz 1997; Schwartz and
Smith 2000). Another approach is to express the hidden factors in
terms of the remaining model parameters and obtain an optimal fit
to the observed curves (futures curve and a curve resulting from
implied volatility of options on futures) at various time points. In
this work, we apply the latter approach and use current spot,
futures, and options on futures to calibrate the model. A key
advantage to this approach is the use of the most recent market
information, and the result will yield the appropriate parameters
for a risk-neutral forecast of future prices.15 In this section, we discuss and illustrate the details required to use the implied volatility
approach to calibrate the SS model.
In the SS price process, the short-term deviations are expected
to fade away by passage of time; this means that if we could study
the expected oil prices far into the future, we would observe only
those price fluctuations related to the long-term factor. Intuitively,
if the long maturity futures and options on futures are available
for the index oil price, then the information contained in those prices can be used for estimation of parameters related to long-term
factor. The volatility of long maturity futures and what is implied
by the options on those futures will give information on the volatility of the Brownian-motion process that describes the dynamics
of long-term factor. On the other hand, the volatility of near-term
futures and what is implied by the options on those futures will
give information on the mean-reverting process that describes the
short-term deviations of the oil prices. The question is, How can
futures and options on futures provide information from which we
can assess the SS model parameters?
The Black-Scholes equation used for valuation of options on
stocks can be used to find the volatility of a stock given the option
price by solving an inverse pricing function using, for example,
Newtons method. In this work, we applied Microsoft Excels
Goal Seek function to find the value for volatility r, which makes
the Black-Scholes price match the observed option price. This
approach was initially applied to options on stocks, where it
works because these options are freely traded in the market and
where it is reasonable to use the GBM approximation to model
the change over time in the underlying market value. For barrels
of oil, the option is traded on the futures contracts and it means
that the underlying asset for the option is a futures contract on oil
price. Thus, we need to apply a different inverse model to assess
the appropriate volatilities for the SS model.
Schwartz and Smith (2000) argue that if we think of commodity prices in terms of their two-factor price model, the prices of
the futures contracts in such a market will be log-normally distrib13
We found it impossible to split the total estimate of ln into separate estimates of ln and
kn, our calibration procedure directly estimates ln .
14
The Kalman filter (Kalman 1960) is used widely for estimating unobserved state variables
and parameters (Harvey 1989; West and Harrison 1996). The Kalman filter produces estimates of a parameter on the basis of measurements that contains noise or other inaccuracies. If historical spot oil prices (values for St) are considered as the measurement, then
because ln(St) nt vt, Kalman-filter methods can provide estimates of nt, which are normally unobservable in the market. These estimates of nt can, in turn, be used to estimate
the parameters of the equation dnt ln dt rn dzn .
15
Note that none of the parameter-estimation approaches will produce the correct parameters, and thus there is no right method. Both the Kalman-filter approach and the implied
volatility approach that we introduce in this paper provide assessments of the price model
parameters. Because the methods are based on different parameters (historical futures
and options vs. current futures and options), they are not directly comparable. The two
approaches could conceivably be compared by looking at a specific decision situation and
investigating the impact of the resulting assessments on the decision policy and its value.
That is beyond the scope of this paper.
Stage:
Page: 161
Total Pages: 13
uted. The fact that market-traded futures prices are log-normally

distributed allows us to write a closed-form expression for valuing
European put and call options on these futures contracts. Assume
FT,t is the price of a futures contract at Time t, with maturity at
Time T. Following Schwartz and Smith (2000), if / ln(FT,t) and
the volatility of ln(FT,t) is r/(t,T), the value of a European call
option on a futures contract maturing at Time T, with exercise
Price K, and Time t until the option expires, is
c ert fFT;0 Nd KNd r/ t; Tg; . . . . . . . . . . . . 6
where
d
lnF=K
1=2r/ t; T: . . . . . . . . . . . . . . . . . . . . . . 7
r/ t; T
and N(d) indicates cumulative probabilities for the standard normal distribution [N(d) p(Z < d)]. The value of a European put
option with the same parameters is
p ert fFT;0 Nd KNr/ t; T dg: . . . . . . . . . 8
Step 1: Estimation of rn. We recorded the prices for options on
futures contracts c, prices for underlying futures contract FT,0, time
to maturity T, strike prices K, and options expiry t that were reported
in the New York Mercantile Exchange on 15 May 2011. The expiries of the options contracts that we used are equal to the maturity of
the futures contract (i.e., T t). On the basis of these values, we
solve the inverse problem to find the volatility r/(t,T) associated
with each options contract. The annualized volatility (used in the
simulation
p of prices and real options valuation) would be
r/ t:T t.
The r/(t,T) can be written in terms of the parameters of the
two-factor model:
r2/ t; T VarlnFT;t e2jTt 1 e2jt
r2n 2ejTt 1 ejt
qnvr vr n
j
r2v
2j :
9
If we again assume that the options expire at the maturity of the

futures contracts, then T t, then e2j(Tt) ej(Tt) 1. Furthermore, it can be shown that as the maturity of the futures contracts
increases (T!1), the implied annualized volatility of the futures
contracts will mostly reflect the uncertainty about the long-term
factor.16 In other words, for large T, Eq. 9 simplifies to
p q
r/ T; T= T r2n : . . . . . . . . . . . . . . . . . . . . . . . 10
Thus, when maturities approach infinity, the implied annual
volatility approaches the volatility of long-term factor rn. We can
insert the implied volatility of options that expire in 6 to 8 years
[i.e., r/(8, 8), r/(7, 7), or r/(6, 6) in Eq. 10] and calculate rn.
Step 2: Estimation of ln and j. The diagram in Fig. 4 shows
the data points obtained from the log of futures prices with various maturity dates. We have fitted a curve (the solid line) to the
discrete data points observed in the market. From now on, this
curve will be called the futures curve. This curve shows that the
log of the futures prices is affected by short-term volatility for
near-term maturity contracts, but as the time to maturity increases,
the effect of the short-term fluctuations fades away. For long maturity futures, the futures curve turns into a straight line, which
has the slope of ln 1=2r2n . Having estimated rn in the previous
step, we can estimate ln , the risk-neutral drift rate for the longterm factor. This curve also reveals a rough estimation for the
mean-reversion coefficient j. The half-life of the deviation is the
length of time that the short-term deviations are expected to halve
and is equal to ln2=j. The curve shows that the short-term
16
When T t, lim
T1
1 ejT
1 e2jT
0 and lim
0.
T1
T
T

161
4.65
Page: 162
Total Pages: 13
0.35
Observed Futures Prices
Implied Volatility of
Observed Option Prices
0.3
4.55
Futures Curve
4.5
Slope = * +
4.45
4.4
0
Half-life = ( 2) /
4
6
Time, years
Annual Volatility
4.6
Log of Prices
Stage:
0.25
0.2
0.15
0.1
Volatility Curve
10
0.05
0
0
Fig. 4The futures curve and its relationship with the meanreversion coefficient.
10
Time, years
Fig. 5The implied volatility of observed options on futures in

the commodity market and the fitted volatility curve.
Log (Prices)
Spot Price
Expected Spot Prices

2
Slope = +
Deviation (0)
Futures Curve
2
Slope = +
Short-Term Risk Premium

(/)
Equilibrium Price (0)
Time
Fig. 6Relationships among parameters of the two-factor price process.
deviations will decrease to half its value in approximately

10 months; this implies a mean-reversion coefficient of
ln2
0:83.
10=12
Step 3: Estimation of rv and qnv. When T t and we work
with near-maturity futures contracts (T 0), it can be shown that
for small T, Eq. 9 results in the annualized volatility as follows17:
p q
e2jT r2v r2n T 2ejT qnv rn rv : . . . 11
r/ T; T= T
p
Eq. 11 shows that the annualized volatility [r/ t; T= T ] for
near-maturity futures contracts (T 0) is the sum of the volatilities of short-term and long-term factors. Because we already calculated rn in Step 1, we can now insert the implied volatility of
options that expire into Eq. 10 (e.g., in 1 to 3 months, resulting in
a system of two equations with two unknowns from which we can
calculate rv and qnv.) Any two of r/ 1=12; 1=12 , r/ 1=6; 1=6 ,
or r/ 1=4; 1=4 , inserted into Eq. 3 will result in such a system of
linear equations.
Fig. 5 shows the implied volatility of observed options on
futures prices taken from NYMEX on 15 May 2011. The fitted
volatility curve is a helpful tool in estimating the implied volatility for far-maturity options prices and extrapolating the trend to
near-maturity (T 0) options prices.18 Note that in all our analysis, T always t because we do not have access to other combinations in the market.
1 e2jT
1 ejT
2j and lim
j.
T!0
T
T
This is equivalent to assessing the nugget effect of a variogram, which is commonly used
to calibrate geostatistical methods. As when assessing the variogram, there is no one correct value for the near-maturity options prices and its determination is subjective and based
on the knowledge and experience of the assessor.
17
We used the fact that, when T t, lim
T!0
18
162
Step 4: Estimation of n0, v0, and kv. We can estimate n0 (the

long-term factor of the spot price at Time 0), v0 (the deviation
from the equilibrium at Time 0), and kv (the risk premium for the
short-term factor) on the basis of the estimations performed in the
previous steps and the relationships between parameters and initial state variables. In this step, the spot and futures prices provide
indirect information about these unknowns. Fig. 6 depicts the
relationships between the model parameters.19
The log of the current spot oil price is the summation of n0 and
v0; therefore, because S0 is observed in the market [West Texas
Intermediate (WTI) spot oil price was USD 99/bbl on 15 May
2011], we can write v0 in terms of n0
v0 lnS0 n0 : . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Eq. 13 shows the relationship between FT,0 (price of the
futures contract at Time 0 with maturity at T) and other model parameters. We have estimated ln , rn, j, rv, and qvn previously.
Furthermore, on the basis of Eq. 4, we can replace v0 with ln(S0)
n0 in Eq. 5. This leaves us with two unknowns, n0 and kv.
kv
lnFT;0 ejT v0 n0 ln T 1 ejT
j
"
#
2
r
q
vn rv rn
v
2
jT
2jT
1=2 1 e
rn T 21 e
:
2j
j
13
19
Note that in Fig. 6 only the data points for the lower curve (the futures curve) are observable in the market. The data points for the upper curve (the expected spot prices) are not
observed in the market and therefore we cannot locate this curve in practice. As a result,
we can estimate the parameters for the risk-neutral process well, but our estimates for the
spot-price process will not be acceptable.

Stage:
Page: 163
Total Pages: 13
TABLE 1ANNUAL PARAMETER ESTIMATES FOR THE TWO-FACTOR OIL-PRICE MODEL

WITH ASSUMED KX50
Parameter
Description
Estimated Value
v0
n0
rn
rv
ln
kv
j
qnv
Short-term increment of the log of the spot price

Long-term increment of the log of the spot price
The volatility of the long-term factor
The volatility of the short-term factor
The risk-neutral drift rate for the long-term factor
The risk premium for short-term factor
Mean-reversion coefficient
The correlation coefficient between the random increments
0.21
4.38
10%
29%
0.5%
0
0.83
0.3
TABLE 2SUMMARY OF PARAMETER-ESTIMATION PROCEDURE

Step 1 - Estimation
of rn
Step 2 Estimation
of ln and j
Step 3 Estimation
of rv and qnv
Step 4 Estimation
of n0, v0, and kv
Calculate implied volatilities for a long-maturity futures contract using Eqs. 6 or 7; then use Eq. 9 and
calculate rn.
Build the log of futures curve based on the observed prices of futures contracts; calculate the slope of the log
of futures curve; estimate ln by subtracting 1=2r2n from the slope.
ln2
Estimate half-life from the futures curve; use the relationship half-life
to estimate j.
j
Calculate implied volatilities for at least two near-maturity futures contracts using Eqs. 6 or 7; build a system
of equations by inserting different implied volatilities in Eq. 10; insert all estimated parameters from Steps 1
and 2 into the system of equations; solve the system of equations and calculate rv and qnv.
Arbitrarily set kv 0; use Eqs. 11 and 12 to build a system of equations; solve the system of equations and
calculate n0 and v0.
As discussed previously, the data points corresponding to the

upper curve of Fig. 6 are not observable in the market. The risk
premiums kv and kn describe the differences between the lower
and upper curve, and because expected prices are not observed,
these risk premiums cannot be estimated. In the risk-neutral version of the SS model, we would need only ln (which is estimated
accurately using the lower curve and eliminates the need for
assessing kn).
The errors in the estimate of kv shift all the estimates of nt up or
down by a constant (kv =j) with vt adjusting accordingly so as to
preserve the sum nt vt corresponding to the log of expected spot
price (Schwartz and Smith 2000). Assume we replace kv by kv D
for any D, and in compensation replace v0 by v0 D=j and n0 by
n0 D=j . These changes will not affect the risk-neutral stochastic
processes. We use this property and arbitrarily set kv 0 in our
estimations (which means D kv). Then, if we use Eqs. 4 and 5
to calculate v0 and n0, our estimates for these initial state variables
will be valid for the risk-neutral version of the SS model.
We can insert the logarithm of price of a futures contract into
Eq. 13, and by setting kv 0, we can estimate n0 and v0 using
Eqs. 12 and 13.
The estimated parameters used in our economic analysis are
shown in Table 1.
The parameter-estimation procedure, the order of the estimates, and the relationships used are summarized in Table 2.
Project Valuation
Introduction. In the classical DCF approach to valuation, the net
present value (NPV) of a project is calculated by discounting the
future expected values using a discount rate that reflects the cost
of capital and desired rate of return. This discount rate is markedly higher than the prevailing risk-free interest rate and hence
can be viewed as a risk-adjusted discount rate. Furthermore, most
corporations use a single discount rate in the analysis of all projects or, at best, establish different discount rates for only a few
large classes (e.g., political, pipeline installation vs. new field
development) of investment decisions. This one-size-fits-all
approach to dealing with projects mimics the risks of the overall
firm, but it fails to reflect the variety of projects that feature different types and levels of uncertainty. Furthermore, using risk-
adjusted discount rates often leads to an undervaluation of numerous oil and gas projects with long-time horizons.
Another major criticism of the classical DCF approach is that
it is based on a static view, in which future decisions are
assumed to depend only on information available now and not on
additional information that would be available when the decision
is made. This ignores management flexibility and the value that is
generated by managements ability to make decisions during the
execution of the project. The value of this flexibility can only be
determined using a real option valuation approach.20
Decision-tree analysis can be used to model flexibilities and
options associated with oil and gas projects. Decisions to maximize the value of the project can be included as downstream decision nodes, allowing the managers to respond as uncertainties
are resolved over the projects life. The resulting decision tree can
then be solved using the same risk-adjusted discount rate judged to
be appropriate for the original project without flexibility. Unfortunately, although this nave approach may provide a representative
model of the project and its management, it does not result in a correct valuation of the real options associated with the project. This
is because the optimization that occurs at each downstream decision node changes the expected future cash flow of the project.
This, in turn, changes the risk characteristics of the project because
the standard deviation of the project without the flexibility is different from that of the project with the flexibility.21
20
Kulatilaka (1995) argues that the real options value reflects the enhanced ability of a firm
to cope with exogenous uncertainty (e.g., uncertainty in prices) and that the value of flexibility, being a more-general concept, refers to the value that is obtained by revising decisions
when uncertainties resolve. In this paper, we use the terms real options and value of
flexibility interchangeably when we discuss situations where value can be created by making decisions at the face of resolving uncertainties.
21
In practice, the difficulties of evaluating any investment opportunity using a single riskadjusted discount rate render the valuation method inconsistent and biased. First, the risks
in a project are not distributed evenly; some variables that affect the cash flows are more
risky than others and we need to have a reliable picture of the aggregate risks and uncertainties in order to apply a single risk-adjusted discount rate to all cash flows. This aggregate
picture of projects risks is usually difficult to define because of the interactions between
uncertainties. Second, the risks of a project are likely to change over time and applying a single risk-adjusted discount rate for valuation does not take this into account. Third, if there
are options (downstream decisions) in a project, exercising these options will affect the aggregate risk profile of the project. Using a single risk-adjusted discount rate without considering this effect will result in evaluation biases.

163
To adjust the nave approach, we can use a risk-neutral pricing

approach (Smith and Nau 1995; Smith and McCardle 1999) by distinguishing between market risks, which can be hedged by trading
securities, and private risks, which are project-specific risks. The
risk-neutral approach provides a single, coherent risk-neutral
model, which is used to estimate the value of the project both with
and without options. In this approach, the probabilities or processes
associated with the uncertainties or stochastic factors in the model
(e.g., oil prices) are risk-adjusted. The value of the investment is
then calculated by determining its expected NPV using the risk
adjusted probabilities or processes for market risks and true probabilities for private risksall discounted at the risk-free rate. As
will be discussed in more detail in Appendix A, risks that fall somewhere between market and private (e.g., rig-rate risks) are assessed
as true probabilities conditional on the concurrent market state.
Combining decision-tree analysis with the risk-neutral approach
provides a consistent and correct approach to the valuation of flexible projects. Unfortunately, decision trees (or binomial lattices) are
awkward to use when the investment decision is a function of multiple uncertainties and involves multiple decision points. The LSM
approach is well suited for such situations because it does not suffer
from the curse of dimensionality with regard to the number of
uncertainties and decision points (Longstaff and Schwartz 2001;
Willigers and Bratvold 2009). Using the LSM approach, we start
by building a Monte Carlo simulation model that takes into account
all relevant uncertainties of the problem. From this model, we generate a large number of possible outcomes for the project without
options. In order to calculate an optimal exercise policy at each decision point, we need to evaluate the expected future payoff (the
continuation value) for each possible choice, conditioned on the resolution of all the uncertainties up to that time. The optimal policy
is then achieved by selecting the option that yields the highest continuation value given the information available.
The challenge is to determine the continuation value, and this
is where Longstaff and Schwartz (2001) suggest the use of linear
regression. The LSM method is applied to find an approximate
value function that relates the continuation value to the underlying
uncertainties. Once the value function has been established, the
estimated continuation value is determined by the realized values
of the uncertainties in a given period.
Abandonment-Timing Option. The timing of the decision to
abandon an oil or gas field can have a significant impact on asset
value. As a simple rule, when the revenues from selling the
extracted hydrocarbons are not sufficient to cover expenses
(including tax) then the field is abandoned. In reality, the uncertain
oil or gas prices, complex cash-flow structures, and interrelated
decisions transform the timing of field abandonment into a complex real option. Most major oil and gas fields produce for 20 to 30
years or more before their production rates decline below an economic limit and continuing the operations would incur a net loss to
the company. At that time, the decision of how and when to terminate the operations will create an important exit option. The project value is the expected sum of cash flows, including those
associated with any inherent options. In some projects, the abandonment option may have a significant impact on project value.22
After the production is closed down, the installations must be
dismantled and removed. Generally, in offshore installations the
topsides are taken to shore for recycling; the substructures may
also be removed or left in place either temporarily or permanently
(subject to regulations and government policies). Dismantling and
removal of large platforms is costly and involves regulatory and
environmental considerations (Osmundsen and Tveteras 2003).
The removal costs are, however, highly uncertain partly because
of the challenging nature of the job and partly because of the
industrys lack of experience in dismantling large offshore con22
Because of the long time span of numerous oil and gas projects, the abandonment decision will be made well into the future and the economic impact of this decision is not considered explicitly in the development decision because of its insignificant impact on the value
of the projects at initiation. In contrast, in the final years of production, the economic impact
of the abandonment decision is significant.
164
Stage:
Page: 164
Total Pages: 13
struction (Parente et al. 2006). There are more than 6,500 offshore
installations worldwide, and Osmundsen and Tveteras (2003) estimated that the cost of removal would exceed USD 20 billion.
Thus, significant value loss or gain potential is associated with the
timing of the abandonment.
Given the uncertain future oil prices, the net cash flows from
oil production will also be uncertain. In this situation, the abandonment decision must be based on the expectation of the future
cash flows, given continued production. The expected future oil
prices and cash flows should be conditional on the current price,
and we call the conditional expectation of the future cash flows
the continuation value, which includes any value gained from
optimal decisions in the future. In uncertain situations, the optimal
course of action would be to compare the value from immediate
abandonment with the continuation value and choose the alternative with the largest value. This view of abandonment decisions
as an American option is discussed in Myers and Majd (1990) and
Berger et al. (1996).
At the time of abandonment, the wells must be plugged and
the infrastructures dismantled. In most fiscal regimes, the operating company is responsible for minimizing the risk of pollution
and keeping the production site in an environmentally acceptable
state. Performing this is costly, the resale value of the existing
equipment is often insignificant, and thus the abandonment of a
field generally requires a significant outlay for the operator.
Osmundsen and Tveteras (2003) studied the decommissioning
costs and policy issues on the Norwegian continental shelf. Their
study reveals numerous sources of uncertainty that impact the
cost of abandoning a field.
In some situations, the field may be acquired by another operator23 or there may be a positive resale value for the facilities and
infrastructure.24 In these situations, the optimal time of abandonment depends on the future oil prices, decommissioning costs,
and the salvage value of the equipment, which are all uncertain.
As an example, consider a field with a floating production, storage, and offloading (FPSO) vessel. At the time of the abandonment, the FPSO vessel can be refitted and reused for another field.
Compared with a field that has been developed using fixed production platforms, the FPSO is a more-flexible asset and may
have a positive salvage value. The salvage value may induce a
different course of action and a different value for the abandonment option compared with a fixed-platform operation. Everything else being equal, flexible equipment that has a secondary
market (compared with custom-built equipment that does not
have a secondary market) increases the abandonment-option value
(Myers and Majd 1990; Berger et al. 1996).
Assume that an operator wants to assess the current value of
the project including the abandonment-timing option. Such a
value estimate may, for example, be relevant in negotiating a
price for the transfer of the operatorship to another party. The production is currently at 1 million bbl/yr and declining. This production level is achieved by spending USD 10 million/yr in the form
of fixed costs and variable operating costs that, for this project,
are well estimated by
average annual oil price 2=5 production rate:25 . . . 14
23
Although a company may abandon a field, the life of the field may not stop at that time. In
some cases, smaller companies with lower overhead costs or lower profit expectations may
take over the field and continue producing from it. In other cases, the national oil company
of the country involved may be interested to take back the field. In these situations, the two
parties can negotiate a transfer price, which is comparable to the project value with abandonment option in our analysis.
24
The emergence of new technologies or discovery of reserves in adjacent areas may
affect the value of facilities because they can still be used for extraction purposes. See
Osmundsen and Tveteras (2003) for a study of policy issues about decommissioning the
production facilities.
25
The cost structure in a project can be far more complex than the simple cost formula
used in this paper. However, we omitted lengthy discussions on the cost structure and its
correlation with other value drivers in order to focus on the valuation part. In another simplifying assumption, we used the end-of-year convention for cash flows (i.e., we assume all
cash flows occur at the end of each year as a lump sum).

Stage:
Page: 165
Total Pages: 13
TABLE 3YEARLY PARAMETERS FOR THE MEAN-REVERTING PROCESS DESCRIBING

THE DYNAMICS OF THE ABANDONMENT CASH FLOWS
Description
Parameter
Value
Mean-Reversion Coefficient
Mean Abandonment Cash Flow
Volatility of Abandonment Cash Flows
a
h
rh
1
USD 30 Million
USD 9 million/yr (30% annual volatility)
If we choose to continue the production in the next year, the

USD 1 million will be expensed irrespective of the amount of production. However, the operating cost varies according to the level
of production and includes the cost of pumping the liquids to the
surface, primary treatments, separation, and transporting the oil to
the supply point. The field is in late life, and the annual production decline has for several years been stable at 10% per year. Historically, a good estimate of the variable cost in each year has
been given.
For the purpose of this paper, we combine the decommissioning costs and salvage values into a single uncertain variable,
which we call the abandonment cash flow, ht, which includes all
decommissioning costs and the resale value of the FPSO and thus
may take on positive or negative values. Assume the example oil
field discussed earlier is producing through an FPSO that has a
positive value in a secondary market. The operator expects that
the abandonment cash flow, ht, of the project is time dependent
and can be modeled by an OU process as follows:
dh ah hdt rh dzh ; . . . . . . . . . . . . . . . . . . . . 15
where a is the mean-reversion rate and rh represents the volatility
of the abandonment cash flow in which the entire abandonment
cash flow is assumed to occur in the year the field is abandoned.26
The operator realizes that the salvage value of the FPSO is correlated with the oil prices, while the decommissioning costs are
assumed to be uncorrelated with the prices. Therefore, ht includes
risks that fall somewhere between the notions of private and market risks. Willigers (2009) looked at historical rig data and found
the correlation between oil price and rig rental rates to be approximately 0.8. Because only a fraction of ht is correlated with the oil
prices,27 the operator decides to use a correlation coefficient of
0.2 for this uncertainty (i.e., qSh 0.2). The other parameters of
the OU process are shown in Table 3.
The LSM Method. Although the literature recognizes the importance of uncertainty in abandonment costs and salvage values
(Myers and Majd 1990), valuing flexibility in light of multiple
uncertainties is difficult using traditional option valuation tools.
With two uncertainties (state variables), one or two trinomial trees
are required and any stochastic process beyond GBM induces
timestep-dependent up and down probabilities (Hahn and Dyer
2008). Going beyond two state variables generally requires some
form of simulation. In this subsection, we illustrate how the LSM
method (Longstaff and Schwartz 2001) can incorporate the key
uncertainties (future oil prices, which themselves consists of two
underlying state variables, and abandonment cash flows) into the
abandonment-timing option, where the uncertainties are treated in
a more-realistic manner than by using GBM processes.
The LSM approach to option valuation starts by building a
Monte Carlo simulation model that takes into account all relevant
uncertainties of the problem. Using this model, we generate a
large number of possible outcomes for the continue to produce

situation. In order to calculate the optimal abandonment policy at
each decision point, we need to evaluate the expected future payoff (the continuation value) for each possible choice (abandon or
continue production), conditioned on the resolution of all the
uncertainties (oil price and abandonment cash flow) up to that
time. The optimal policy is then achieved by selecting the option
that yields the highest value given the information available.
The challenge is to determine the continuation value, and this
is where Longstaff and Schwartz (2001) suggested the use of linear regression. The LSM method is applied to find an approximation to the conditional value expectation given the realized, or
current, values of the uncertainties in a given time period.
In this work, we want to assess the value of the flexibility to
abandon the field at any given point in time. The optimal abandonment time will be assessed on the basis of the information we
have about the production level, decline rate, oil-price dynamics,
and abandonment-cash-flow fluctuations. In our analysis, the cash
flows before Year 0 are treated as sunk costs and will not affect
any calculations. We assume the field must be abandoned within
the next 15 years.28 The cash flow at any given year depends on
the (average) oil price on that year, St; the abandonment cash flow
of the project, ht; and the decision, dt, to abandon or to continue
the project. We denote the payoff in the period (t, t Dt) as P(St,
ht, dt, t). We denote the present value of all future cash flows (on
the basis of optimal decisions and discounted at the risk-free discount rate, r) as F(St, ht, t). The optimal decision at Year t is to
choose the course of action that maximizes the present value of
current cash flows along with the expected cash flows from optimal decisions in the future. This is shown as the following
dynamic programming equation:29

PSt ; ht ; dt ; t erDt E
FSt ; ht ; t max
; . . . . . . . 16
d
FStDt ; htDt ; t Dt
where E() is the expectation operator. We use the integrated riskneutral valuation procedure described in Smith and Nau (1995).
The oil price is treated as a market uncertainty, which can be
hedged in the commodity markets using suitable market instruments. The abandonment cash flow is a technical uncertainty, but
obviously has a correlation with oil prices. In our model, we
determine the expected yearly cash flows by calculating trajectories for oil prices and abandonment cash flows using the risk-neutral processes. All discounting is performed at a risk-free rate of
3%. See Appendix A for further discussion on risk-neutral
valuation.
Because we will use Monte Carlo simulation to generate prices
and cash flows, we need to discretize the SS processes and the
mean-reverting process that describes the abandonment cash flow.
The following time-discrete equations have been used.
lnst vt nt : . . . . . . . . . . . . . . . . . . . . . . . . . . 17
26
In order to keep the example simple, we assume all tax benefits or expenses are already
included in ht.
27
In our model, h is categorized as a private uncertainty because it cannot be hedged in

the market. However, this variable is correlated with the market uncertainty (oil prices) and
it will thus be represented by a process conditional on the concurrent market. Smith (2005)
discusses that calculating such a conditional probability has the same effect as risk adjusting this uncertainty. In general, if the private uncertainties are correlated with market uncertainty, we should either use risk-adjusted processes for these factors or directly correlate
them with the market uncertainty.
28
For practicality, we have to assume a finite time horizon for this valuation problem. The
choice of the time horizon depends on analysis needs and should be realistic for the problem. In this paper, we also assume the value-maximizing decisions are made on the basis
of expected values.
29
Also known as the Bellman equation, this equation is the necessary condition for optimality associated with our dynamic programming model. See Bertsekas (2005) for an introduction to dynamic programming.

165
Frequency
2,500
2,000
1,500
1,000
34.08
45.22
56.37
67.52
78.67
89.81
100.96
112.11
123.25
134.40
145.55
156.70
167.84
178.99
190.14
201.28
212.43
223.58
234.72
245.87
257.02
500
Abandonment Cash Flow,

2, USD Million
Eq. 4 is the continuous time version of the stationary firstorder autoregressive process in discrete time (Dixit and Pindyck
1994). The exact discrete model (valid for large Dt) for the riskneutral short-term component process is
r
1 e2jDt

jDt
jDt kv
1 e
rv ev
;
vt vt1 e
j
2j
19
where en and ev in Eqs. 18 and 19 are standard normal random
variables and are correlated in each time period with the correlation coefficient qnv. It can be shown (Wiersema 2008) that if en
and e are two independent normal random variables, we can correlate the price processes in Eqs. 18 and 19 by constructing the random variable for the second process as
q
ev en qnv e 1 q2nv : . . . . . . . . . . . . . . . . . . . . . 20
The risk-neutral process used for simulation of abandonment
cash flows is
r
1 e2aDt
aDt
aDt
h1 e
rh eh
: . . . . 21
ht ht1 e
2a
0.5519
0.0012
0.0013
0.0007
0.0024
0.0021
0.0057
0.003
0.0123
0.0088
0.0326
0.102
0.0179
0.1
0.0548
0.5
0.2033
Probability of Abandonment
Again eh is the standard normal random variable. As we discussed in the preceding subsection, the uncertainty about the
abandonment cash flow is technical uncertainty but has a correlation with the oil prices. We used Eq. 20 to correlate the abandonment cash flow with the long-term factor of the oil prices.
We can solve this dynamic programming problem by starting
at the final date T Year 15 and then working backward to the
current date by solving the associated Bellman equation at all the
decision dates t Year 15, , Year 1. Our decisions should take
into account the expectation of the uncertainties about future time
0.2
Abandon the Oil Field
Continue Operation
3
60
110
160
210
260
Fig. 8Decision map for Year 2.
The discretization for the long-term component, Eq. 5, is

p
nt nt1 ln Dt rn en Dt: . . . . . . . . . . . . . . . . . 18
0.3
Total Pages: 13
Second Year Oil Price, S2 (USD/bbl)
Fig. 7Distribution of the project outcomes.
0.4
Page: 166
15
Project value, USD Million
0.6
Stage:
periods. It is difficult to directly assess the conditional expected

continuation value E[F(StDt, VtDt, t Dt)], and, as discussed
next, we approximate this by a regression function. In this paper,
we numerically solve the dynamic-programming model using the
LSM method.
The LSM algorithm uses the regression equation as the estimator of the future values conditional on the current information (the
conditional expectation value). In this regression, the current state
variables (simulated oil prices and abandonment cash flows) are
the independent variables. The decision outcomes (cash flows
received in the future) are then used to predict the dependent variable. With this regression equation, one can simply insert current
state values and obtain a prediction for the future values.
We ran a simulation of 10,000 trials and determined the nearoptimal decisions in each year (the details of the LSM implementation are discussed in Appendix B). Using these near-optimal
decision policies, we found an expected NPV of USD 107.92 million for the project.
Analysis of Results and Discussion. The option value calculated
in the preceding subsection is an expected value and is based on
our modeling of the underlying uncertainties. While this number
gives a positive option-value estimate, it may be useful to also
look at the range of possible outcomes and associated frequencies.
In Fig. 7, the output of the LSM simulation has been presented in
the form of a frequency diagram. This figure shows that on the basis of the results of this simulation, some scenarios result in NPV
values higher or lower than USD 107.92 million.
It would also be beneficial to know what the optimal decision
is on the basis of the value of the state variables. For example, if
in Year 2 the oil price is S2 and the abandonment cash flow is h2,
then what would be the optimal decision? For what range of the
state variables should the decision maker abandon the project and
for what range should the operations continue? Fig. 8 shows a
policy map that can provide insight for these questions.
Fig. 9 shows the outputs of the LSM algorithm presented in a
different format. This diagram shows the probability that the project is abandoned in each year, given the information available in
Year 0. Such presentations can provide valuable insight for the
decision makers. As an example, this diagram reveals that in
5,519 iterations out of 10,000 iterations, the optimal decision was
to abandon the project in the first year.30
We can compare the value of the abandonment-timing option
with the case in which the field has to be abandoned no later than
a particular time (when, for example, contracts or authorities force
the company effectively to abandon the field no later than a particular time). Fig. 10 shows the market value of the project for a
range of different levels of operating flexibility. The horizontal
axis shows the latest possible time for the project to be abandoned. For example Year 2 means the project can be abandoned
in either Year 1 or Year 2.
30
Fig. 9Probability of abandoning the project in each year,

given the information available at Year 0.
166
Note that Fig. 9 shows the probabilities for abandoning the field conditional on the information in Year 0. The decision maker may also want to know the probabilities of abandoning the field in a specific year, conditional on not having abandoned the field in previous
years. This information can be also extracted from the outputs of the LSM algorithm.

107.92
107.92
107.87
107.79
107.66
107.51
107.31
106.96
106.41
105.43
104.02
101.75
97.84
91.98
110
105
100
95
90
85
80
75
70
Stage:
Page: 167
Total Pages: 13
Steve Begg, whose valuable comments, suggestions, and insights

helped improve this paper.
References
81.26
Project Value, USD Million
Degree of Flexibility
Fig. 10Project value for different ranges of operating

flexibilities.
Clearly, from Fig. 10, increased flexibility with regard to the

abandonment time can add significant value. For this example, the
value increase is largest in the first years and then levels off at
approximately Year 7.
Conclusions
In this paper, we have illustrated the details of the parameterization, using the implied volatility approach with futures and
options data, and implementation of the SS two-parameter stochastic price process. We then implemented a real option valuation model for an abandonment option using the LSM formulation
and the SS price process.
The real options paradigm recognizes the value-creation potential resulting from decision makers active management of their
investments over time. Modeling the price uncertainty using a
two-factor stochastic price process provides a realistic implementation of oil-price dynamics and, thus, a realistic option value.
The LSM method implemented here readily generalizes to
more-complex problems. We used a second-degree polynomial
equation in our regression to estimate the conditional expected
value of continuation in our example. There are other problems in
which using a simple regression function is unsuitable [see Stentoft (2004) for discussion on the convergence of this estimator to
the true conditional expectation value]. In general, we can add
any number of terms, including nonlinear terms to the regression
equation as required by the problem context. The complexity of
the regression equation does not impose limitations on the efficiency of the LSM algorithm, and the LSM algorithm is relatively
insensitive to the number of uncertainties in the problem, but its
complexity grows with the number of decision points and the
number of alternatives at each decision point.
We also illustrated an implied approach for calibration of the
SS model to market data. This method of parameter estimation is
relatively simple and practical, relies on forward market data as
opposed to historical data, and should encourage analysts and decision makers to include realistic models of oil-price uncertainties
in their valuation efforts. It should be noted that there is uncertainty or variability in the model parameters because the calibration is based on futures prices that change on a frequent basis. If
this is a concern, it is possible to use average values or values
determined by the decision maker (e.g., the chief financial officer
for numerous oil companies). For a better understanding of the
impact of this uncertainty, a sensitivity analysis of project values
and associated decisions based on the variability of model parameters should always be conducted.
In this paper, we analyzed a generic example of project abandonment without considering any tax effect. Clearly, analyzing
the abandonment option under different tax regimes may have a
significant impact on the optimal abandonment time.
Acknowledgments
We thank James E. Smith for his response to our questions. We
also thank the two anonymous reviewers and Associate Editor
Baker, M.P., Mayfield, E.S., and Parsons, J.E. 1998. Alternative Models
of Uncertainty Commodity Prices for Use with Modern Asset Pricing
Methods. Energy Journal 19 (1): 115148. http://dx.doi.org/10.5547/
ISSN0195-6574-EJ-Vol19-No1-5.
Begg, S.H. and Smit, N. 2007. Sensitivity of Project Economics to Uncertainty in Type and Parameters of Price Models. Paper SPE 110812 presented at the SPE Annual Technical Conference and Exhibition,
Anaheim, California, USA, 1114 November. http://dx.doi.org/10.2118/
110812-MS.
Berger, P.G., Ofek, E., and Swary, I. 1996. Investor valuation of the abandonment option. Journal of Financial Economics 42 (2): 257287.
http://dx.doi.org/10.1016/0304-405x(96)00877-x.
Bertsekas, D.P. 2005. Dynamic Programming and Optimal Control, third
edition, Vol. 1. Belmont, Massachusetts: Athena Scientific.
Bickel, J.E. and Bratvold, R.B. 2008. From Uncertainty Quantification
to Decision Making in the Oil and Gas Industry. Energy Exploration and Exploitation 26 (5): 311325. http://dx.doi.org/10.1260/
014459808787945344.
Brennan, M.J. and Schwartz, E.S. 1985. Evaluating Natural Resource
Investments. The Journal of Business 58 (2): 135157.
Carriere, J.F. 1996. Valuation of the early-exercise price for options using
simulations and nonparametric regression. Insurance: Mathematics
and Economics 19 (1): 1930. http://dx.doi.org/10.1016/s0167-6687(96)
00004-2.
Cortazar, G. and Schwartz, E.S. 1994. The Valuation of Commodity Contingent Claims. The Journal of Derivatives 1 (4): 2739. http://
dx.doi.org/10.3905/jod.1994.407896.
Cortazar, G. and Schwartz, E.S. 2003. Implementing a stochastic model
for oil futures prices. Energy Economics 25 (3): 215238. http://
dx.doi.org/10.1016/S0140-9883(02)00096-8.
Cox, J.C., Ingersoll, J.E. Jr., and Ross, S.A. 1985. An Intertemporal
General Equilibrium Model of Asset Prices. Econometrica 53 (3):
363384. http://dx.doi.org/10.2307/1911241.
Cox, J.C. and Ross, S.A. 1976. The valuation of options for alternative stochastic processes. Journal of Financial Economics 3 (12): 145166.
http://dx.doi.org/10.1016/0304-405x(76)90023-4.
Cox, J.C., Ross, S.A., and Rubinstein, M. 1979. Option pricing: A simplified approach. Journal of Financial Economics 7 (3): 229263. http://
dx.doi.org/10.1016/0304-405x(79)90015-1.
Dias, M.A.G. 2004. Valuation of exploration and production assets: an
overview of real options models. J. Pet. Sci. Eng. 44 (12): 93114.
http://dx.doi.org/10.1016/j.petrol.2004.02.008.
Dias, M.A.G. and Rocha, K.M.C. 1999. Petroleum Concessions with
Extendible Options Using Mean Reversion with Jumps to Model the
Oil Prices. Paper prepared for presentation at the 3rd International
Conference on Real Options, Wassenaar/Leiden, The Netherlands, 68
June. http://www.realoptions.org/papers1999/MarcoKatia.pdf.
Dickey, D.A. and Fuller, W.A. 1981. Likelihood Ratio Statistics for
Autoregressive Time Series with a Unit Root. Econometrica 49 (4):
10571072. http://dx.doi.org/10.2307/1912517.
Dixit, A.K. and Pindyck, R.S. 1994. Investment Under Uncertainty.
Princeton, New Jersey: Princeton University Press.
Geman, H. 2000. Scarcity and price volatility in oil markets. Technical
Report, EDF Trading, London.
Geman, H. 2005. Commodities and Commodity Derivatives: Modelling
and Pricing for Agriculturals, Metals and Energy. West Sussex, UK:
John Wiley & Sons.
Gibson, R. and Schwartz, E. 1990. Stochastic Convenience Yield and the
Pricing of Oil Contingent Claims. The Journal of Finance 45 (3):
959976. http://dx.doi.org/10.2307/2328801.
Glasserman, P. 2004. Monte Carlo Methods in Financial Engineering,
Vol. 53. New York: Applications of MathematicsStochastic Modelling and Applied Probability, Springer-Verlag.
Hahn, W.J. and Dyer, J.S. 2008. Discrete time modeling of mean-reverting
stochastic processes for real option valuation. European Journal of
Operational Research 184 (2): 534548. http://dx.doi.org/10.1016/
j.ejor.2006.11.015.

167
Harrison, J.M. and Pliska, S.R. 1981. Martingales and stochastic integrals in
the theory of continuous trading. Stochastic Processes and their Applications 11 (3): 215260. http://dx.doi.org/10.1016/0304-4149(81)90026-0.
Harvey, A.C. 1989. Forecasting, Structural Time Series Models and the
Kalman Filter. Cambridge, UK: Cambridge University PressCambridge University Press.
Hilliard, J.E. and Reis, J. 1998. Valuation of Commodity Futures and
Options Under Stochastic Convenience Yields, Interest Rates, and
Jump Diffusions in the Spot. The Journal of Financial and Quantitative Analysis 33 (1): 6186. http://dx.doi.org/10.2307/2331378.
Kalman, R.E. 1960. A New Approach to Linear Filtering and Prediction
Problems. Journal of Basic Engineering 82 (1): 3545. http://
dx.doi.org/10.1115/1.3662552.
Kulatilaka, N. 1995. The Value of Flexibility: A General Model of Real
Options. In Real Options in Capital Investment: Models, Strategies,
and Applications, ed. L. Trigeorgis, Part II-5, 89108. Westport, Connecticut: Praeger Publishers.
Laughton, D.G. and Jacoby, H.D. 1993. Reversion, Timing Options, and
Long-Term Decision-Making. Financial Management 22 (3):
225240.
Laughton, D.G. and Jacoby, H.D. 1995. The Effects of Reversion on Commodity Projects of Different Length. In Real Options in Capital Investment: Models, Strategies, and Applications, third printing edition, ed.
L. Trigeorgis, Part IV, 185206. Westport, Connecticut: Praeger
Publishers.
Longstaff, F.A. and Schwartz, E.S. 2001. Valuing American options by
simulation: A simple least-squares approach. Rev. Financ. Stud. 14
(1): 113147. http://dx.doi.org/10.1093/rfs/14.1.113.
Luenberger, D.G. 1998. Investment Science. New York: Oxford University
Press.
Merton, R.C. 1973. An Intertemporal Capital Asset Pricing Model. Econometrica 41 (5): 867887. http://dx.doi.org/10.2307/1913811.
Myers, S.C. and Majd, S. 1990. Abandonment Value and Project Life.
Advances in Futures and Options Research 4: 121.
Osmundsen, P. and Tveteras, R. 2003. Decommissioning of petroleum
installationsmajor policy issues. Energy Policy 31 (15): 15791588.
http://dx.doi.org/10.1016/s0301-4215(02)00224-0.
Paddock, J.L., Siegel, D.R., and Smith, J.L. 1988. Option Valuation of
Claims on Real Assets: The Case of Offshore Petroleum Leases. The
Quarterly Journal of Economics 103 (3): 479508. http://dx.doi.org/
10.2307/1885541.
Parente, V., Ferreira, D., Moutinho dos Santos, E. et al. 2006. Offshore
decommissioning issues: Deductibility and transferability. Energy Policy 34 (15): 19922001. http://dx.doi.org/10.1016/j.enpol.2005.02.008.
Pilipovic, D. 1998. Energy Risk: Valuing and Managing Energy Derivatives. New York: McGraw-Hill.
Pindyck, R.S. 1999. The Long-Run Evolution of Energy Prices. The
Energy Journal 20 (2): 127.
Pindyck, R.S. 2001. The Dynamics of Commodity Spot and Futures Markets: A Primer. The Energy Journal 22 (3).
Schwartz, E.S. 1994. Review of Investment Under Uncertainty, Dixit A.K.
and Pindyck R.S. The Journal of Finance 49 (5): 19241928.
Schwartz, E.S. 1997. The Stochastic Behavior of Commodity Prices:
Implications for Valuation and Hedging. The Journal of Finance 52
(3): 923973. http://dx.doi.org/10.1111/j.1540-6261.1997.tb02721.x.
Schwartz, E. and Smith, J.E. 2000. Short-Term Variations and Long-Term
Dynamics in Commodity Prices. Management Science 46 (7):
893911. http://dx.doi.org/10.1287/mnsc.46.7.893.12034.
Smith, J.E. and McCardle, K.F. 1999. Options in the Real World: Lessons
Learned in Evaluating Oil and Gas Investments. Oper. Res. 47 (1):
115. http://dx.doi.org/10.1287/opre.47.1.1.
Smith, J.E. and Nau, R.F. 1995. Valuing Risky Projects: Option Pricing
Theory and Decision Analysis. Management Science 41 (5): 795816.
http://dx.doi.org/10.1287/mnsc.41.5.795.
Smith, J.E. 2005. Alternative Approaches for Solving Real Options Problems (Comment on Brandao et al. 2005). Decision Analysis 2 (2):
89102. http://dx.doi.org/10.1287/deca.1050.0041.
Stentoft, L. 2004. Convergence of Least Squares Monte Carlo Approach
to American Option Valuation. Management Science 50 (9).
Tsitsiklis, J.N. and van Roy, B. 1999. Optimal stopping of Markov
processes: Hilbert space theory, approximation algorithms, and an
168
Stage:
Page: 168
Total Pages: 13
application to pricing high-dimensional financial derivatives IEEE

Transactions on Automatic Control 44 (10): 18401851. http://
dx.doi.org/10.1109/9.793723.
Tsitsiklis, J.N. and van Roy, B. 2001. Regression methods for pricing
complex American-style options IEEE Trans. Neural Networks 12 (4):
694703. http://dx.doi.org/10.1109/72.935083.
Uhlenbeck, G.E. and Ornstein, L.S. 1930. On the Theory of the Brownian
Motion. Physical Review 36 (5): 823841. http://dx.doi.org/10.1103/
PhysRev.36.823.
West, M. and Harrison, J. 1996. Bayesian Forecasting and Dynamic Models, second edition. New York: Springer-Verlag.
Wiersema, U.F. 2008. Brownian Motion Calculus. West Sussex, UK: John
Wiley & Sons.
Willigers, B.J.A. 2009. Practical Portfolio Simulation: Determining the
Precision of a Probability Distribution of a Large Asset Portfolio when
the Underlying Project Economics are Captured by a Small Number of
Discrete Scenarios. Paper SPE 124180 presented at the SPE Annual
Technical Conference and Exhibition, New Orleans, 47 October.
http://dx.doi.org/10.2118/124180-MS.
Willigers, B.J.A. and Bratvold, R.B. 2009. Valuing Oil and Gas Options
by Least-Squares Monte Carlo Simulation. SPE Proj Fac & Const 4
(4): 146155. SPE-116026-PA. http://dx.doi.org/10.2118/116026-PA.
Appendix A: Risk-Neutral Valuation of

Uncertainties That Fall Between Market
and Private Uncertainties
Traditional DCF analysis considers uncertainty in cash flows as a
source of risk. In order to reflect the effects of risk on the project
value, the common approach has been to risk adjust the discount
rate. In performing this, we make a number of assumptions. First,
when we risk adjust the discount rate, we treat all cash flows (and
elements of cash flows subject to various sources of risk) equally,
as if the risk is distributed uniformly across all elements of the
cash flows.31 Second, using a single risk-adjusted discount rate
for valuations also implies a constant risk level over time, whereas
the risks of a project usually vary with time.32 Third, when the
risk-adjusted discount rates are used in decision trees or dynamic
programs, at each decision point the risk characteristics of a project will change as a result of the optimization. This will result in
an underestimation of project value.
In the risk-neutral valuation technique (Cox et al. 1985),33 the
value of an investment in a complete market is the discounted
expected value of its future payoffs under the risk-neutral probabilities. In other words, we risk adjust probabilities and stochastic
processes associated with uncertainties in the model. Then, we
calculate the expected NPV of the investment using these riskneutral probabilities or processes and discount them at the riskfree rate. On the basis of the equilibrium risk-neutral scheme
described in Cox et al. (1985), the risk premium ki for uncertain
Variable i on the basis of Mertons (1973) intertemporal capital
asset pricing model is a function of rim (the covariance between
the uncertain factor and the market), r2m (the variance of the market), r (the risk-free rate), and rm (the expected return on the market portfolio), following the equation
rim
rm r: . . . . . . . . . . . . . . . . . . . . . . . . . A-1
r2m
rim
In Eq. A-1, 2 can be regarded as beta of the uncertain Varirm
able i. Such a risk premium can be used, for example, to risk
adjust the oil-price process by deducting it from the drift rate of
ki
31
In most projects, the elements of cash flows have different degrees of uncertainty. For
example, royalties, tariffs, or booking costs are usually significantly less uncertain than the
revenues.
32
For example, a major oil-producing field is considered significantly less risky when it is
matured compared with the early development phases. In general, the uncertainty about
recoverable oil volume tends to decrease with a projects maturity.
33
The risk-neutral valuation scheme for option valuation was developed in Cox and Ross
(1976). Other applications of risk-neutral valuation include Cox et al. (1979) for discretetime models and Harrison and Pliska (1981) for continuous models.

Stage:
Page: 169
Total Pages: 13
TABLE B-1ANNUAL CASH FLOWS AND ABANDONMENT CASH FLOWS FOR SEVEN SAMPLE PATHS
Path 1 Oil Price (USD/bbl)

h (USD Million)
h (USD Million)
h (USD Million)
h (USD Million)
h (USD Million)
h (USD Million)
h (USD Million)
Year
1
Year
2
Year
3
Year
4
Year
5
Year
6
Year
7
Year
8
Year
9
Year
10
Year
11
Year
12
Year
13
Year
14
Year
15
97.1
28.93
72.1
40.87
71.2
55.97
85.6
44.39
63.7
57.24
57.1
58.93
72.3
53.02
65.0
56.35
60.8
33.27
78.8
44.73
118.6
30.83
64.6
63.09
51.2
51.56
54.1
54.97
53.6
53.26
110.7
40.58
80.3
44.11
139.8
38.13
46.2
37.94
56.1
5.27
52.0
19.65
57.3
33.57
67.5
35.09
46.7
49.77
133.2
13.93
65.2
63.86
64.4
49.04
64.1
48.19
44.1
31.17
62.2
47.21
69.1
57.87
84.1
13.35
45.2
55.69
57.3
40.14
64.0
34.66
53.2
32.46
47.4
34.82
69.6
52.66
103.8
40.82
41.5
48.98
65.5
42.82
34.9
52.40
43.6
56.20
32.4
77.64
64.2
61.99
65.2
50.91
66.3
56.69
72.2
26.12
34.9
59.96
52.5
36.97
41.9
31.55
78.9
28.40
80.8
35.34
78.6
61.07
59.8
41.12
61.0
50.41
64.1
27.69
43.0
40.38
121.2
42.33
54.2
50.18
53.4
54.46
63.6
47.72
66.9
41.35
77.3
38.75
36.7
41.11
69.0
61.90
73.5
64.41
55.4
56.94
68.3
84.36
51.3
39.83
70.3
29.08
39.5
54.07
103.9
44.96
98.5
67.60
71.7
51.89
109.3
48.64
62.7
26.50
114.7
36.00
43.8
57.60
128.3
60.76
102.0
33.47
63.0
28.71
102.1
58.17
78.1
29.37
104.9
42.63
44.4
53.22
94.3
45.69
96.5
67.06
75.9
61.79
58.3
71.76
105.4
12.75
93.3
64.43
43.5
67.12
79.9
31.30
72.1
66.18
52.3
61.76
54.2
64.59
68.6
57.53
70.8
58.73
32.5
55.11
71.6
49.27
81.8
64.15
45.7
81.85
51.6
38.35
88.2
37.93
the process. If an uncertain factor is uncorrelated to the market

movements, then its risk premium is zero and does not need risk
adjustment. All the cash flows generated using these probabilities
and stochastic processes are discounted using the risk-free discount rate [see Luenberger (1998) for a discussion on risk-neutral
valuation].
Smith and Nau (1995) proposed a modification to this
approach in which uncertainties are divided into market uncertainties (those that can be hedged in the market by trading securities) and private uncertainties (those that cannot be hedged in the
market). The expected NPV of the investment is calculated using
the risk-adjusted probabilities or processes for market uncertainties and assessed probabilities for private uncertainties. The
dependence between market and private risks is captured by
assessing true probabilities for the private risks conditional on the
contemporaneous market state (Smith 2005).
We may not always be able to categorize all uncertainties into
either market or private uncertainties. Some uncertainties
(e.g., the uncertainty about abandonment cash flow in our example) may fall somewhere between these two categories. However,
we should note that only those uncertainties that can be hedged
with market instruments are considered market uncertainties.
Oil-price uncertainty is an example of a market uncertainty because in major commodity markets there are futures and options
on futures contracts available to hedge the oil-price uncertainty.34
The price of other crudes produced from specific fields should be
judged on the basis of their correlation with traded crude types and
may not be regarded easily as market uncertainty. Those uncertainties that cannot be hedged using market instruments should be
regarded as private uncertainties, even though they may be related
to market uncertainties. As discussed by Smith (2005), if private
uncertainty p has a correlation with market uncertainty m, then in
the decision-analytic risk-neutral approach, we should use the true
probabilities for p conditional on the contemporaneous state of m.
If we assume p and m are correlated with correlation coefficient
qpm, then the conditional stochastic process for p will have a reduction equal to bp(lm r), where r is the risk-free rate, lm is the
rp rpm
return on market uncertainty m, and bp qpm
2 can be
rm
rm
interpreted as beta of uncertainty p in a fashion similar to Eq. A-1.
We expect that the risk-neutral valuation scheme is a moreconsistent valuation approach in that each individual uncertainty is
risk adjusted separately, whereas risk adjusting the discount rate

for the aggregate project level, although possible, is prone to errors
and requires harder judgments. Once the uncertainties are risk
adjusted, they also can be used across different projects. Furthermore, it is more plausible to assume that risk adjustments for
uncertainties stay constant over time. Finally, projects with options
can be modeled more consistently using this method because
changing the course of a project can alter exposure to some uncertainties but will not affect the risk characteristic of the individual
factors.
Appendix B: Numerical Valuation
A simulation with 10,000 trials generates 10,000 paths for oil prices and abandonment cash flows from the equations offered in
The LSM Method section. These values are then used in a spreadsheet to create 10,000 paths for the Year 0 to Year 15 cash
flows.35 Out of all simulated paths, seven paths are presented in
Tables B-1 and B-2. These paths represent seven scenarios that
will result in different abandonment decisions. For example, in
Path 1, the cash-flow becomes negative in Year 7 because of a
decrease in the oil prices and decline in the production rate. The
yearly cash flow will change sign two more times before the project is abandoned in Year 14.
The owner may abandon the project any time between Years 1
and 15. If the owner decides to abandon, he or she will receive
that years cash flow and the prevailing abandonment cash flow.
In some other cases, it may be better to continue the production
and take advantage of higher oil prices and abandonment cash
flows in the future. In our LSM implementation, we should consider these decision policies in each year and find the optimum
abandonment time for each path of the simulation. The LSM algorithm cannot provide a course of action better than the decision
alternatives we improvised in the first place; it is thus important to
emphasize the creative thinking and come up with the value-creating decision alternatives.
The LSM algorithm starts at Year 15 and determines the optimal decision conditional on not abandoning the project in previous years. If the oil field is still generating positive cash flows at
Year 15, we would have no choice other than to abandon. The
optimal decision at Year 15 would then be to abandon in all
10,000 paths.
The next step would be to determine the optimal decision in
Year 14. The cash flow in Year 14 is observable directly by the
decision maker and can be used in the decisions. At this stage, the
34
In terms of the decision-analytic risk-neutral valuation, only a few crude-oil types (WTI
crude oil traded in NYMEX, Brent crude traded in IntercontinentalExchange, and a few
other crudes) are actively traded in the futures markets. The price uncertainty in these
crudes can be hedged using the market instruments, and we can categorize them as market uncertainties.
35
We used a 15-year time horizon in our example because the production beyond that time
was negligible. In the Conclusions section, we discussed the effect of time horizon (and
number of subperiods) in the efficiency of LSM simulation.

169
Stage:
Page: 170
Total Pages: 13
TABLE B-2CASH-FLOW MATRIX FOR THE SEVEN SAMPLE PATHS

NPV (USD Year
Million)
1
Path 1
Path 2
Path 3
Path 4
Path 5
Path 6
Path 7
109.930
142.475
133.611
228.003
74.431
119.211
78.856
37.441
23.952
23.464
31.250
76.664
15.849
24.015
Year
2
Year
3
Year
4
Year
5
Year
6
Year
7
Year
8
Year
9
16.607
14.564
23.321
42.659
9.886
11.297
8.433
33.431
20.145
46.149
9.539
7.763
7.546
11.556
3.401
37.438
10.336
10.233
0.642
7.023
9.487
14.806
5.303
7.679
1.959
0.102
7.189
18.105
5.876
3.870
2.493
71.934
65.414
3.714
5.729
4.996
1.445
5.875
0.457
0.758
0.090
2.399
0.218
0.560
owner has to decide between abandoning at Year 14 and continuing production until Year 15. If the owner decides to abandon the
project in Year 14, the immediate payoff would be the Year 14
cash flow along with the Year 14 abandonment cash flow. If the
decision maker decides to continue production, he or she will
receive the cash flows from Years 14 and 15. Because information
about Year 15 cash flows is not available at Year 14, the decision
maker should be able to estimate the Year 15 cash flow on the basis of the information available at Year 14. Such estimation is
made with the help of a regression function. The general form for
such a regression function is as follows:
EFS15 ; V15 ; t a1 S14 a2 h14 a3 S214 a4 h214
a5 S14 h14 b: B-1
We use a two-factor stochastic model to describe the variability of the oil prices, meaning that the oil price St is a function of
two stochastic factors nt and vt. To include all this information in
the regression function, Eq. B-1 can be expanded as follows:
EFS15 ; V15 ; t a01 n14 a001 v14 a2 h14 a03 n214 a003 v214
a4 h214 a5 n14 h14 a6 v14 h14 a7 n14 v14 b:
B-2
The coefficients of the regression function can be estimated by
the LSM using the simulation data. The 10,000 data points from
Year 14 oil prices and abandonment cash flows serve as the independent variables, and 10,000 data points from Year 15 decision
outcomes serve as the dependent variables.
The LSM algorithm compares immediate payoffs with the
expected future payoffs in each path. If the current cash flow is
positive, and the regression function estimates an expected positive payoff in the future, the LSM algorithm chooses to continue
to the following year. On the other hand, if the current cash flow
is negative, or the regression function estimates an expected negative payoff in the future, the LSM algorithm chooses to abandon
the project. After the optimal abandonment decisions are determined for a year, the LSM algorithm moves one step back to the
previous year and repeats this procedure until the optimal decisions in all years are determined.36
Year
10
Year
11
Year
12
Year
13
Year Year
14
15
1.175 1.760 4.442 1.003 62.237
64.782
83.652
4.276 3.191 1.770 1.078 51.945
The LSM algorithm is a backward recursion approach applied

to multistage decision problems. At each decision point, the optimal decision alternative is determined with an eye to the evolution
of the uncertainty in the future. The algorithm should also consider that the abandonment can occur only once during the 15
years. After the optimal decisions are determined for each path,
the algorithm looks for the earliest abandonment date and assigns
the value of zero to cash flows that occur after this date. For
example, if in a path the earliest abandonment date determined by
the LSM is Year 9, the algorithm assigns the value of zero to cash
flows in Years 10 through 15. Applying this process to all paths
will generate the cash-flow matrix. This matrix is shown in Table
B-2 for the sample paths presented in Table B-1.
In the cash-flow matrix, all cash flows from Year 0 to the year
of project abandonment are reported. To calculate the value of the
project with the abandonment option, the NPV of the cash flows
for each path is calculated and then averaged over all paths.
Babak Jafarizadeh is currently a senior analyst in Statoil, Norway, and his research interests include real option valuation,
decision analysis, and portfolio management in the oil and
gas industry. He holds a PhD degree in petroleum investment
and decision analysis from the University of Stavanger and an
MSc degree in financial engineering from Amirkabir University
of Technology (Tehran Polytechnic) in Iran.
Reidar B. Bratvold is a professor of petroleum investment and
decision analysis at the University of Stavanger and at the Norwegian University of Science and Technology in Trondheim,
Norway. His research interests include decision analysis, representing and solving decision problems in the upstream oil and
gas industry, valuation of risky projects, portfolio analysis, and
behavioral challenges in decision making. Before entering
academia, Bratvold spent 15 years in the industry in various
technical and management roles. He is a coauthor of SPE
primer Making Good Decisions. Bratvold is an associate editor
for SPE Economics & Management and has twice served as
an SPE Distinguished Lecturer. He was made a member of the
Norwegian Academy of Technological Sciences for his work in
petroleum investment and decision analysis and is also an
elected Fellow with the Society of Decision Professionals. Bratvold holds a PhD degree in petroleum engineering and an
MSc degree in mathematics, both from Stanford University,
and has business and management-science education from
INSEAD and Stanford University.
36
Clearly, the LSM algorithm is an approximate algorithm and the resulting decisions will
be near-optimal, which will generate a near-optimal value for the abandonment flexibility
[see Glasserman (2004) for a review of the approximation biases].
170


Two Factor Oil Price Model

Enviado por

Dados do documento

Direitos autorais

Formatos disponíveis

Compartilhar este documento

Compartilhar ou incorporar documento

Opções de compartilhamento

Você considera este documento útil?

Este conteúdo é inapropriado?

Direitos autorais:

Formatos disponíveis

Two Factor Oil Price Model

Enviado por

Direitos autorais:

Formatos disponíveis

EM162862 DOI: 10.

2118/162862-PA Date: 19-July-12

Two-Factor Oil-Price Model and Real

consider them as stochastic processes that evolve over time)2

C 2012 Society of Petroleum Engineers

Simulation-based valuation of American options using nonparametric regression methods

July 2012 SPE Economics & Management

EM162862 DOI: 10.2118/162862-PA Date: 19-July-12

Oil Price, USD/bbl

assume further that there is an uncertain abandonment cash flow

Oil-Price Modeling: An Introduction to Stochastic

contracts are now dominating the process of world-wide oil-price

Statistical analysis may be used to investigate whether GBM or mean-reverting processes

July 2012 SPE Economics & Management

EM162862 DOI: 10.2118/162862-PA Date: 19-July-12

Oil Price, USD/bbl

Oil Price, USD/bbl

dvt jvt dt rv dzv ; . . . . . . . . . . . . . . . . . . . . . . . 3

July 2012 SPE Economics & Management

EM162862 DOI: 10.2118/162862-PA Date: 19-July-12

uted. The fact that market-traded futures prices are log-normally

If we again assume that the options expire at the maturity of the

July 2012 SPE Economics & Management

EM162862 DOI: 10.2118/162862-PA Date: 19-July-12

Observed Futures Prices

Fig. 5The implied volatility of observed options on futures in

Expected Spot Prices

Short-Term Risk Premium

Equilibrium Price (0)

deviations will decrease to half its value in approximately

We used the fact that, when T t, lim

Step 4: Estimation of n0, v0, and kv. We can estimate n0 (the

July 2012 SPE Economics & Management

EM162862 DOI: 10.2118/162862-PA Date: 19-July-12

TABLE 1ANNUAL PARAMETER ESTIMATES FOR THE TWO-FACTOR OIL-PRICE MODEL

Short-term increment of the log of the spot price

TABLE 2SUMMARY OF PARAMETER-ESTIMATION PROCEDURE

As discussed previously, the data points corresponding to the

July 2012 SPE Economics & Management

EM162862 DOI: 10.2118/162862-PA Date: 19-July-12

To adjust the nave approach, we can use a risk-neutral pricing

July 2012 SPE Economics & Management

EM162862 DOI: 10.2118/162862-PA Date: 19-July-12

TABLE 3YEARLY PARAMETERS FOR THE MEAN-REVERTING PROCESS DESCRIBING

If we choose to continue the production in the next year, the

large number of possible outcomes for the continue to produce

In our model, h is categorized as a private uncertainty because it cannot be hedged in

July 2012 SPE Economics & Management

Abandonment Cash Flow,

EM162862 DOI: 10.2118/162862-PA Date: 19-July-12

Abandon the Oil Field

Fig. 8Decision map for Year 2.

The discretization for the long-term component, Eq. 5, is

Second Year Oil Price, S2 (USD/bbl)

Fig. 7Distribution of the project outcomes.

Project value, USD Million

periods. It is difficult to directly assess the conditional expected

Fig. 9Probability of abandoning the project in each year,

July 2012 SPE Economics & Management

Steve Begg, whose valuable comments, suggestions, and insights

Project Value, USD Million

EM162862 DOI: 10.2118/162862-PA Date: 19-July-12

Fig. 10Project value for different ranges of operating

Clearly, from Fig. 10, increased flexibility with regard to the