Real Options Approach for a Staged Field Development With Optional Wells

The decreasing average size of new discoveries in mature production areas makes the base of oil field investment decisions more uncertain than ever before. Fewer appraisal wells, which allow to decrease the amount of subsurface uncertainty, are typically drilled before the development of a small field compared to large fields. Therefore, new solutions are required to make small discoveries commercial given both technical and market uncertainties. Therefore, accounting for managerial flexibilities that enable to change the course of the project due to new information, becomes even more important for investment valuation. Combining the real options approach and decision analysis we present a novel model that allows to identify additional value created by a sequential drilling strategy for field development under oil price and resource uncertainty. We capture the sequence of key investment and operating decisions of a marginal field development in cooperation with an oil industry partner building a synthetic (yet realistic) project case. Addressing the flexibility to divide production wells drilling into two stages, we evaluate the option to wait to expand the production by drilling additional wells after the revelation of reservoir information based on a least-squares Monte Carlo algorithm. We identify the conditions under which the staged (phased) development is preferred compared to standard development. Furthermore, we propose a decision rule determining the optimal expansion timing based on new information on the reservoir and the oil price uncertainty. Our results suggest that staged development carries large upside potential for marginal field development under extensive reservoir uncertainty. We also illustrate that partial hedging against the downside risks within a staged development can improve project's economy significant enough to justify investment.