Publications

Option pricing tcchiiiques (OPT) are financial valuation tools that estimate the net present value of upside opportunities associated with uncertainty Equity traders havc uscd options for many years and a mathematical formalism has arisen to estimate their value When the uncertainty is large and the time to resolve the uncertainty is sufficiently long, an option may be large.The energy industry is built upon developtncnt and exploitation of large capital projects that have many opportunities during the life of the project to capturc upside value and to liinit cxposure to the downside. Traditional discounted cash flow (DCF) analysis may not adequately charactcrizc the opportunities. Managing these investments requires managing the uncertainties of cost, coniniodity price, production profiles, market capacity, and the value of incremental knowledge. The industry manages these uncertainties by making incremental investments that exploit increasing knowledge of the opportunity. This is particularly true for investments with break-even economics or with lifetimes more than twenty-five years. Estimating a potential value of future incremental investnicnt opportunities embedded in large capital projects can be done using OPT. The incremental value recognized by OPT rcflects management ability to adjust prqjcct scope, investment rate, production rates, etc., to accomodate uncertainties related to price, in arket, and resource availability.Mobil is extending OPT to capital budgeking to improve its long tcrni project valuations, manage technology applications, and opttmt7e investnicnt timing This article discusses some extcnsions made to OPT for capital budgcting issues, illustrates its application to a development program, and suggests opportunities for applications in the industry.