Why real options value is different of the static net present value (NPV)?

Answer with example: the ** option to expand**.

- Suppose a manager embed an option to expand into her project, by a cost of US$ 1 million;
- The static NPV = - 5 million if the option is exercise today, and in future is expected the same negative NPV;
- Spending a million $ for an expected negative NPV: Is the manager becoming crazy?

**Uncertainty Over the Expansion Value**:

Considering combined uncertainties: in product prices and demand, exercise
price of the real option, operational costs, etc., the future value (2
years ahead) of the expansion has an expected value of $
- 5 million. The figure below illustrates
that.

The traditional discount cash will not recommend to embed an option to
expansion which is expected to be negative.

But the expansion is an option, not an obligation!

Rational managers will not exercise the option to expand @ t = 2 years in
case of bad news (negative value), only will exercise the options in case
of good news.

- Option will be exercised only if the NPV > 0. So, the unfavorable scenarios will be pruned (for NPV < 0, value = 0);
- The
leverage prospect valuation.**options asymmetry**

So, Real Option Value = + 5.

See the "visual equation" below:

Look the above "equation" and answer: What happen
with the option value if the uncertainty is higher (with the same mean)?

Simple: both negative values and positive ones become more spread out.
But the negative values doesn't matter because with option a NPV negative
become zero, however the upside has a higher value in this case,
increasing the option value.

This is an alternative explanation of why uncertainty increases the value
of the real option.

Let us show an **example of option to expand**
the production for a petroleum E&P (exploration & production)
case.

The figure below shows the E&P investment as a sequential option
process. See in particular the last phase (producing asset phase).

Analyzing a large ultra-deepwater project in Campos Basin, Brazil, we faced two problems:

- Remaining technical uncertainty of reservoirs is still important. In this specific case, the better way to solve the uncertainty is by looking the production profile instead drilling additional appraisal wells
- In the preliminary development plan, some wells presented both reservoir risk and small NPV.
- Some wells with small positive NPV (not “deep-in-the-money”) and others even with negative NPV;
- Depending of the initial production information, some wells can be not necessary.

**Solution**: leave these wells as **optional
wells**

Allocate only a small but important investment to permit a fast and low
cost future integration of these wells, depending of both market (oil
prices, costs) and the production profile response. This cost comprises
the cost to leave stand-by both area and load in the production platform
for the optional new wells, and a subsea lay-out so that permits an easy
integration with the existing system in case to exercise some of the
option to drill these optional wells.

So the development project is not optimized statically, it is optimized
dynamically considering the uncertainties and the options created into the
project basic design.

Modeling the Option to Expand, step-by-step:

- Define the quantity of wells “deep-in-the-money” to start the basic investment in development;
- Define the maximum number of optional wells;
- Define the timing (or the accumulated production) that the reservoir information will be revealed;
- Define the scenarios (or distributions) of marginal production of
each optional well as function of time.

Consider the depletion if we wait after learn about reservoir; - Add market uncertainty (modeling as a stochastic process as the model of reversion + jumps for oil prices);
- Combine uncertainties using Monte Carlo simulation (risk-neutral simulation if possible, next FAQ);
- Use optimization method to consider the earlier exercise of the option to drill the wells, and calculate option value.

Monte Carlo for American options is a frontier research area. See the page on Monte Carlo for Real Options.

Petrobras-PUC are starting a research project using Monte Carlo for real options (American type). The idea is to select the best mutually exclusive alternative under uncertainty to develop an oilfield.