Charles Osborne of BP provides a basic introduction to the concept of the real option, highlighting real option as a valuable alternative for investment decisions in a risky business that is strictly dependent upon the volatility of oil prices and the introduction of new technologies.
Kristine Petrosyan, Deputy Editor-in-Chief, TWA
Francesco Verre, Editor, Economist's Corner
There have been countless books written on real options—huge tomes filled with complicated mathematical formulas for working out their value. So, when I was asked to write an article on real options, I had to question myself. Where should I start, and, for that matter, where should I stop?
I did not want to (and indeed could not) write an article for mathematicians. Hence, in this article, I hope to provide you with a simple definition of real options and an understanding of why they can be valuable. And, finally, I would like to summarize why thinking about creating real options can be more beneficial than knowing how to value real options.
Real options refer to options associated with real assets, such as pipelines, oil fields, or gas-storage assets, as opposed to financial options, which are generally associated with buying or selling company shares, bonds, or foreign exchange. Real options give the holder the flexibility to react to future uncertainty as more information becomes available. So, why is this valuable?
Let’s take developing an oil field as an example. We have discovered an oil field and negotiated the right to develop or abandon it at any time over the next 10 years. When we perform traditional discounted-cash-flow (DCF) analysis, using our best-guess assumptions, we discover that the net present value (NPV) of developing the field now is negative USD 300 million. If we believe our assumptions, clearly we would not want to develop the field now.
However, in this instance, we have a real option. We have the right, but not the obligation, to develop the field now, so we can defer our decision into the future.
Let’s move forward 10 years. Technology has now advanced, reducing development costs. Oil prices have increased, and it looks as if they will remain high. The DCF analysis now shows the NPV to be positive USD 500 million.
Wow, doesn’t this sound great!
Well, in this set of circumstances, it is. We were fortunate that technology advanced faster than predicted a decade ago and that oil prices increased beyond our best guess. These uncertainties have made our real option to defer very valuable.
This is all very well, but what would have happened had circumstances turned out differently. What if technology had not advanced and oil prices had not increased? The NPV of developing the field would have remained negative, and we would have chosen not to develop the field. The option to defer would have had no value.
However, the real option did have a cost. We said that we had to negotiate the right to develop the discovery at any time over the next 10 years. The cost of the real option would have been the fee paid to obtain the deferral clause.
The key to valuing real options is to work out whether the potential payoff is greater than the cost to obtain the real option. Real options very rarely come for free!
The valuation of real options can be performed by a variety of methods, but they all have one thing in common. The option value increases as volatility or uncertainty of the outcome increases. In the example above, there was tremendous uncertainty about what could happen to the world in the next 10 years. The option to defer a decision until better information and higher certainty existed was tremendously valuable. Had there been no uncertainty, we would not have needed a real option.
The great thing about real options is that they can be created and developed if an organization gives sufficient thought to them early in a project. Real options can be created on decisions to stage investments as markets develop, to shut in and restart production as prices change, to expand or contract assets or businesses as demand shifts, to switch fuels or raw materials as relative prices change, or to divert cargoes to the highest-priced market. The list is almost endless.
Real options should be used by organizations first and foremost as a way of thinking. Real options very rarely create themselves; they have to be created and defined, sometimes through skilful negotiation and sometimes through strategic thinking and wise investment decisions.
A thorough investigation of all the possible project alternatives should be the starting point. Each alternative should be tested to ensure that it fits with company strategy. The organization should then undertake a thorough risk-and-reward analysis to narrow the alternatives to a manageable number.
| Charles Osborne is a member of the Financial Evaluation and Skills team of BP. He has worked for BP for 10 years in a number of commercial roles within the gas and power businesses. Osborne now enjoys using this experience to teach finance and investment- appraisal techniques and to give advice on financial documentation being prepared for sanction. He graduated from the University of East Anglia with a BS in accounting. |