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Project Economics in the Big-Bets Industry: The Integrated Valuation in Practice.

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Title: Project Economics in the Big-Bets Industry: The Integrated Valuation in Practice.
Authors: Jafarizadeh, Babak1 (AUTHOR) b.jafarizadeh@hw.ac.uk, Bratvold, Reidar B.2 (AUTHOR) reidar.bratvold@uis.no
Source: Journal of Petroleum Science & Engineering. Feb2021, Vol. 197, pN.PAG-N.PAG. 1p.
Subjects: Discounted cash flow, Financial leverage, Valuation of investments, Valuation, Petroleum prospecting
Abstract: Value creation from petroleum projects is uncertain. Yet, even with great odds of failure, companies increasingly take on these ventures. Here, no analytics could cut failures out. We could only avoid loss by avoiding poor investment decisions. In practice, most valuations use inconsistent principles that potentially obscure the value–maximizing decisions. For example, when drilling for hydrocarbons most firms decide which opportunity to drill based on their expected value—calculated from values of multiple outcomes, each with different levels of uncertainty but traditionally evaluated with a single discount rate. The all-inclusive discounting could lead to biases and poor decisions. In this paper, we discuss the shortcomings of the traditional approach and implement a coherent method of integrated valuation that, while more detailed, excels in valuation of uncertain investments. • Traditional discounted cash flow implementation in decision trees creates inherent inconsistencies. • It would be best to separate discounting for time value of money from discounting for risk. We suggest the risk-neutral valuation to account for risks. • In practice, the risk-neutral valuation still requires judgment. • We discuss practical aspects such as financial leverage, basis risk, and correlated risks in the context of a petroleum exploration example. [ABSTRACT FROM AUTHOR]
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Database: Engineering Source
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Abstract:Value creation from petroleum projects is uncertain. Yet, even with great odds of failure, companies increasingly take on these ventures. Here, no analytics could cut failures out. We could only avoid loss by avoiding poor investment decisions. In practice, most valuations use inconsistent principles that potentially obscure the value–maximizing decisions. For example, when drilling for hydrocarbons most firms decide which opportunity to drill based on their expected value—calculated from values of multiple outcomes, each with different levels of uncertainty but traditionally evaluated with a single discount rate. The all-inclusive discounting could lead to biases and poor decisions. In this paper, we discuss the shortcomings of the traditional approach and implement a coherent method of integrated valuation that, while more detailed, excels in valuation of uncertain investments. • Traditional discounted cash flow implementation in decision trees creates inherent inconsistencies. • It would be best to separate discounting for time value of money from discounting for risk. We suggest the risk-neutral valuation to account for risks. • In practice, the risk-neutral valuation still requires judgment. • We discuss practical aspects such as financial leverage, basis risk, and correlated risks in the context of a petroleum exploration example. [ABSTRACT FROM AUTHOR]
ISSN:09204105
DOI:10.1016/j.petrol.2020.108095