A Method for Volatility Estimation for Application in Real Options Approach

Traditional project evaluation based on discounted cash flow analysis which ignores the upside potentials to an investment from managerial flexibility and innovation is not a suitable approach for evaluating high risk projects such as projects in oil industry. Nowadays, real options valuation approach that borrows ideas from financial options attracts the expert's attentions. In spite of the fact that experts have paid attention to this new method, applying this approach has some limitations. For applying this method successfully, we need to estimate some input parameters. One of the most important ones is volatility. volatility is a key parameter, but it is difficult to estimate. From a traditional investment viewpoint, volatility reduces project value because it increases its discount rate via a higher risk premium. The estimation of project volatility is very complicated since there is not a historical series of project values and most of projects are done for the first time and they are irreversible. In this article a method based on present value of future cash flows that we named profitability index and Monte Carlo simulation is proposed to estimate the volatility of projects. This method is applied to estimate the volatility of south pars gas field development phase 15 &16 as a case study.