Abstract
The average size of discovered petroleum reserves on the Norwegian continental shelf has declined steadily over the last years. As a consequence, the fields have become economically more marginal, and new and flexible development strategies are required. This paper describes a stochastic dynamic programming model for project evaluation under uncertainty, where emphasis is put on flexibility and its value. Both market risk and reservoir uncertainty are handled by the model, as well as different flexibility types. The complexity of the problem is a challenge and calls for simple descriptions of the main variables in order to obtain a manageable model size. Results from a case study reveal significant value of flexibility, and clearly illustrate the shortcoming of today's common evaluation methods. Particularly capacity flexibility should not be neglected in future development projects where uncertainty surrounding the reservoir properties is substantial.
This is a preview of subscription content, log in via an institution to check access.
Similar content being viewed by others
References
J.S. Aronofsky and A.C. Williams, The use of linear programming and mathematical models in underground oil production, Management Science 8 (1963) 394–407.
E.M.L. Beale, A mathematical programming model for the long-term development of an off-shore gas field, Discrete Applied Mathematics 5 (1983) 1–9.
P. Bjerksund and S. Ekern, Managing investment opportunities under price uncertainty: From "last chance" to "wait and see" strategies, Financial Management (Autumn 1990) 65–83.
H. Bjørstad, T. Hefting and G. Stensland, A model for exploration decisions, Energy Economics 11 (1989) 189–200.
M.J. Brennan, Capital asset pricing model, in: Finance, eds. J. Eatwell, M. Milgate and P. Newman (Macmillan Press, London, 1989) pp. 91–102.
T.E. Copeland and J.F. Weston, Financial Theory and Corporate Policy, 3rd ed. (Addison-Wesley, Reading, MA, 1988).
J.C. Cox, S.A. Ross and M. Rubinstein, Option pricing: A simplified approach, Journal of Financial Economics 7 (1979) 229–263.
A.K. Dixit and R.S. Pindyck, Investment Under Uncertainty (Princeton University Press, Princeton, NJ, 1994).
S. Ekern, An option pricing approach to evaluating petroleum projects, Energy Economics (April 1988) 91–99.
L. Frair and M. Devine, Economic optimization of offshore petroleum development, Management Science 21 (1975) 1370–1379.
J.C. Hull, Option, Futures, and Other Derivative Securities, 2nd ed. (Prentice-Hall, Englewood Cliffs, NJ, 1993).
D. Laughton, The management of flexibility in the upstream petroleum industry, The Energy Journal 19 (1998) 83–113.
O. Lia, H. Omre, H. Tjelmeland, L. Holden, T. Egeland, T. Andersen, A. MacDonald, O.D. Hustad and Y. Qi, The great reservoir uncertainty study-GRUS, in: PROFIT-Project Summary Report, eds. J. Olsen, S. Olaussen, T.B. Jensen, G.H. Landa and L. Hinderaker (The Norwegian Petroleum Directorate, Stavanger, 1995).
M.W. Lund, Stochastic dynamic programming-determination of rate of return, in: Conference Proceedings, NOAS '95, 18–19 August 1995, University of Iceland, Reykjavík, Iceland (1995).
M.W. Lund, The value of flexibility in offshore oil field development projects, Dr. Ing. thesis, The Norwegian University of Science and Technology, Trondheim (1997).
R. McDonald and D. Siegel, The value of waiting to invest, The Quarterly Journal of Economics (November 1986) 707–727. 14 Installation of a subsea template, offshore loading facilities, control systems, installation costs.
J.W. McFarland, L. Lasdon and V. Loose, Development planning and management of petroleum reservoirs using tank models and nonlinear programming, Operations Research 32 (1984) 270–289.
NOE: Norwegian Petroleum Activity. Fact Sheet 2000, Royal Ministry of Petroleum and Energy, Oslo (2000).
A.N. Nystad, Petroleum-reservoir management: Reservoir economics, Dr. Tech. thesis, NTH, University of Trondheim, Norway (1985).
T.E. Olsen and G. Stensland, Optimal shutdown decisions in resource extraction, Economic Letters 26 (1988) 215–218.
J.L. Paddock, D.R. Siegel and J.L. Smith, Option valuation of claims on real assets: The case of offshore petroleum leases, The Quarterly Journal of Economics (August 1988) 479–508.
E. Pickles and J.L. Smith, Petroleum property valuation: A binomial lattice implementation of option pricing theory, The Energy Journal 14 (1993) 1–26.
R.S. Pindyck, Options, flexibility and investment decisions, M.I.T. Center for Energy Policy,Working Paper No. EL–88–018WP (March 1988).
J.W. Pratt, H. Raiffa and R. Schlaifer, Introduction to Statistical Decision Theory (MIT Press, Cambridge, 1995).
J.E. Smith and K.F. McCardle, Options in the real world: Lessons learned in evaluating oil and gas investments, Operations Research 47 (1999) 1–15.
J.E. Smith and K.F.McCardle, Valuing oil properties: Integrating option pricing and decision analysis approaches, Operations Research 46 (1998) 198–217.
G. Stensland and D.B. Tjøstheim, Optimal decisions with reduction of uncertainty over time-an application to oil production, in: Stochastic Models and Option Values, eds. D. Lund and B. Øksendal (North-Holland, Amsterdam, 1991) pp. 267–291.
B.S. Tennfjord, —Verdien av prøveproduksjon på eit oljefelt ("The value of test production of an oil field"), Beta 1 (1990) 35–44 (in Norwegian).
A.J. Triantis and J.E. Hodder, Valuing flexibility as a complex option, The Journal of Finance XLV (1990) 549–565.
S.W. Wallace, C. Helgesen and A.N. Nystad, Optimal Development of An Oil Field, CMI report no. 852310–9, Chr. Michelsen Institute, Bergen (1985).
S.W. Wallace, C. Helgesen and A.N. Nystad, Production Profiles for Oil Fields, CMI report no. 852310–8, Chr. Michelsen Institute, Bergen (1985).
Author information
Authors and Affiliations
Rights and permissions
About this article
Cite this article
Lund, M.W. Valuing Flexibility in Offshore Petroleum Projects. Annals of Operations Research 99, 325–349 (2000). https://doi.org/10.1023/A:1019284119505
Issue Date:
DOI: https://doi.org/10.1023/A:1019284119505