Dealing With Uncertainty in Petroleum Exploration:

1
2001 Energy Finance Conference Austin, Texas
Dealing With Uncertainty in Petroleum
Exploration Anadarkos Use of Real Options

Ron Bain and Steve Rutherford Technology and
Exploration Planning Group Anadarko Petroleum
Corporation
February 22 - 23, 2001
2
Industry Status of Real Options

• Recognized Leaders in Real Options
• Anadarko
• Shell
• Enron
• Mainly Strategic Uses Implemented at Corporate
  Level
• High Level of Interest Throughout the Industry

3
Status of Real Options in Anadarko

• Primarily Strategic Applications Implemented at
  Corporate Level
• Deep Water Lease Sale Valuations
• Farmout Opportunities
• Play Entry Options
• Starting to be Implemented at Division Level
• Stochastic NPV Evaluations are Beginning to
  Include Optionality

4
Timeline

• 1995 - Began Internal Research on Applications of
  Real Options to EP Project Valuations
• Formal recognition of significant value of
  inherent optionality (intuitive to quantitative)
• Literature searches
• Attacked simple problems with Black-Scholes eqn.
• Valuing international PSAs Lease sale bid
  valuations
• 1996 - Realized We Were Sorely Lacking in Tools
  to Solve Real World Problems
• Changed focus to Active Learning types of
  problems
• Consulted with Analysis Group Economics (Martha
  Amram)
• Developed methodologies for valuing active
  learning
• Developed Two-Learn prototype software

5
Timeline

• 1997 to 1998 - Digestion Period
• Implemented qualitative Real Options company wide
• Management (some) developed a Real Options mind
  set
• No consultants or software developments during
  this period
• 1999 - Renewed Focus on Tool Development
• Retained Larry Chorn of ROCE, Inc. to advise on
  Real Options implementations
• Focused on more complex, real world problems
• Employed Rainbow Options value deep water lease
  sale prospects incorporating
• Technology development option
• Explore/abandon option
• Delineate/develop option
• Proprietary software development

6
Timeline

• 2000 - Increasing Commitment to Real Options
• Continuing consultancy with ROCE (Real Options
  course)
• Increased Real Options staff in Exploration
  Planning Group
• Increased Real Options valuations in operating
  groups
• Exploring liaisons with companies to facilitate
  tool development
• Underwriting development of FlexAble
• Networking the Real Options community

7
Extensions to Real Options

• Many times, real asset valuations with the
  following attributes can be re-formulated in
  terms of a Real Options Problem
• Contingent decision making opportunities exist
• Uncertainties to be resolved
• Well defined time frame in which to act

8
Contingent Decision Making

• Options convey the right, but not the obligation
  to invest
• Purchasing an offshore lease can be viewed as an
  option to explore without an obligation to
  develop, etc.
• Lumpy cash flows often reveal contingent decision
  making opportunities
• ROA captures the value associated with the
  ability to bailout and cut ones losses

9
Uncertainties to be Resolved

• Uncertainties that are resolved by time and/or
  effort
• Passive Resolution (Waiting)
• Waiting for price information
• Not particularly useful for projects with long
  timelines
• Active Resolution (GG s)
• Shoot seismic to refine reserves estimates
• Drill delineation wells

10
Timeframe In Which to Act

• A well defined timeframe in which uncertainties
  must be resolved
• Lease period
• PSA exploration time period
• Exploration program time period

11
Real Options Variable Mapping

• S Present value of cash flows associated with
  the project, i. e., value of production less
  operating costs
• X Cost associated with acquiring the cash flows
  (S)
• Development costs, plant expansion costs, etc
• ? Volatility of S to be resolved in option
  period std. deviation of ln(S) / Option time
  period
• Can be associated with price uncertainty,
  reserves size uncertainty, or both
• ?initial - ?final
• t Lease period, etc.
• r Corporate hurdle rate, WACC
• Option Cost - Cost associated with resolving
  uncertainty
• Cost of a well, cost of a seismic program, etc
• Cost of deferring revenue during option period

12
Real Options Variable Mapping
S PV of Production Less Op Costs
T
Cost of Op s spent to prove reserves
X Development Costs
? Std Devln(S)/T Std Dev(S) / ltSgtT r WACC
or hurdle rate Conventional NPV S - X e-rt -
Costs
13
The Investment Opportunity

• A deepwater lease sale is planned in the near
  future.
• There is limited data regarding the amount of oil
  in
• the region. Major uncertainties include the
  volume of oil in
• the leases offered, the cost of developing the
  field(s), and
• the price of oil.
• The exploratory lease duration is 10 years an
  economic field
• will require in excess of 500 MM in investment
  and will produce
• up to 20 years.
• Flexibilities embedded in the investment
  opportunity include
• developing lower cost production facilities
• drilling exploration wells to resolve oil
  volume,
• timing of the development decision.

14
Questions to Resolve

• How much to bid ?
• How much to spend developing new production
  technology ?
• Sufficient information exists to justify
  exploration wells ?
• Develop a discovery or perform further
  appraisal drilling ?
• Synergies exist with other exploration
  opportunities ?

15
Timing Considerations

• 10 year maximum exploratory lease duration
• 2.5 years required to explore
• 3 years required for construction
• 3 years required for alternate technology
  development

16
The Decision Pathway (first stage)
No
EXIT
Begin Exploration
ltthreshold
Yes
Success (gtthreshold)
Win Lease
Success, (?X reduction)
Yes
Failure
Begin Technology Development
No
17
The Decision Pathway
No
EXIT
Begin Exploration
Further Appraisal
ltthreshold
EXIT
No
Begin Reduced Cost Development
Yes
Success (gtthreshold)
Win Lease
Yes
REVENUE
Yes
EXIT
No
18
The Decision Pathway
No
EXIT
Begin Exploration
Further Appraisal
ltthreshold
EXIT
No
Begin Reduced Cost Development
Yes
Success (gtthreshold)
Win Lease
Yes
REVENUE
Yes
Success, (?X reduction)
Yes
EXIT
No
Failure
Begin Technology Development
No
REVENUE
Yes
Begin Full Cost Development
19
Real Option Framework
Opportunity
Option Equivalent
American
Technology
Development
Exploration wells
Up-and-In
Barrier
Appraise vs.
American
Develop now
20
Real Option Framework
American vs European options

• European (Black Scholes)
• exercise only at end of option life
• relatively high valued
• American (Bjerksund and Stensland Approximation)
• exercise anytime up to (including) last day
• based on a trigger price
• consistent with decision flavor
• more accurate as time increases
• fast solution

21
Real Option Framework
Up-and-in Barrier options

• Value of Development option is underlying asset
• 0, if volume discovered lt threshold
• gt 0, if volume discovered gt threshold
• Begins out of money
• Periodic monitoring of barrier hits
• Proof of geologic concepts raises value above
  barrier
• makes development option valuable
• establishes contingent value of development
  option
• barrier adjusts to technology development success
• More conservative than standard B-S (compound
  or sequential)

22
Up-and-in Barrier option on a Binomial tree
Develop option value gt 0
Economic Threshold for volume
Develop option value lt 0
23
Model Inputs
Production capacity (1 FPSO) 180,000 bbl /
day Average oil price 15.00 / bbl Field
decline begins after 75 production Production
decline 10 / year Risk free rate 6.
Company WACC 12. Lease lifetime w/o
production 10 years Tax rate 33
Depreciation schedule 4 years OPEX 65 MM /
year
24
Major Sources of Uncertainty

• Oil Price
• Recoverable volumes
• Development costs

25
Selecting Critical Variables
27
Recoverable Volume
-19
13
-26
Oil Price
21
Development Cost
0
change in Project NPV
26
Components of Project Value _at_ 300 MM bbls
129
118
103
Project NPV (MM)
Total
Explore or Exit
Technology Development
Traditional Analysis
27
Effect of Volume on Project Value
300 250 200 150 100 50 0 -50
Traditional DCF Technology Development
Option Exploration Option Develop vs. Appraise
Option
Project NPV (MM)
200 250 300
350 400
Total Recoverable Volume (MM bbls)
28
Effect of Volume on Project Value
Traditional DCF Technology Development
Option Exploration Option Develop vs. Appraise
Option
200 150 100 50 0 -50
Project NPV (MM)
150 200
250 300 350
29
Interpretations

• Traditional DCF is not linear in this problem due
  to a
• production capacity constraint
• Exploration option has value when you depart from
  the
• optimum ratio of production capacity and field
  size
• Technology Development option has diminishing
  value as
• traditional DCF value rises
• Develop vs. Appraise option has value only at
  volumes just below the economic threshold

30
Effect of Timetable Changes
Technology development option Exploration
option Appraise vs. develop now option
100
75
Option Value (MM)
50
25
-1 0
1
(delay)
(accelerate)
years
31
Effect of Option Expiration

• No bid
• Technology
• development
• Exploration
• Appraise vs.
• develop now

No revenues
Higher development costs
Capital savings vs. no future revenue
Revenue deceleration
32
Conclusions

• Compound options required to represent a
  sequential investment program
• Exotic options sometimes required to capture
  decision flavor
• Dynamic investment model for duration of
  investment lifecycle
• Near breakeven NPV, option values can be very
  large

33
Issues Within Anadarko

• Lack of General Set of Tools
• Impacts ability to solve useful problems
• Impacts ability to disseminate of Real Options
  technology
• Corporate Understanding of Real Options
• How do we explain this stuff to management and
  staff?
• Strategic vs. tactical applications - helicopter
  philosophy
• Buy-In/Credibility
• Where are the corporate experts housed? TURF
• Do people really believe the results? Corporate
  patience
• Very important to present examples where Real
  Options valuation says dont do this project -
  neutralize the bias!

34
Issues Popular Misconception 1

• ROA uses a risk-free discount rate for everything
  - This cant be right!
• In ROA income and expense cash flows are always
  discounted using the companys specified hurdle
  rate
• By analogy to financial options, strike price, X,
  is often discounted using the risk-free rate, but
  only during the option period, t
• r is also the drift rate and impacts the asset
  value volatility model

35
Discount Rates in Financial Options

• The use of the risk-free rate arises from the
  concept of a risk-free portfolio
• The value of a financial option is established
  within the context of a risk-free portfolio
• Assumption - Equities market is efficient and
  frictionless
• Requirement - Risk free portfolio must be free of
  arbitrage risk
• Result - Use of risk-free interest rate is
  mandatory

36
Discount Rates in Real Options

• Through analogy to financial options many
  practitioners often use the risk-free rate
• Natural to compare stock returns to a risk free
  interest rate
• Real markets are different
• Neither efficient nor frictionless
• Arbitrage risk is generally not a factor
• Funds invested in OG projects must earn the
  corporate hurdle rate
• Funds not invested in a project are not generally
  banked. They are diverted to other projects
  earning WACC
• Bottom Line - Anadarkos Philosophy is to use r
  corporate hurdle rate/WACC in Real Options
  valuations

37
Issues Popular Misconception 2

• ROA is just a way to make dog projects appear to
  be valuable
• ROA identifies and values upside potential in a
  project
• Whether the option is a good deal or not depends
  on the cost of the option relative to the value
  of the option
• In financial options cost of option is by
  definition value of the option. NOT SO IN REAL
  OPTIONS!
• Paying more than the option is worth destroys
  project value
• Paying less ensures meeting hurtle rate
  requirements
• Sows ears will not be turned into silk purses by
  ROA

38
2001 Energy Finance Conference Austin, Texas
Dealing With Uncertainty in Petroleum
Exploration Anadarkos Use of Real Options
Ron Bain and Steve Rutherford Technology and
Exploration Planning Group Anadarko Petroleum
Corporation
February 22 - 23, 2001