Stochastic analysis of a shale gas investment strategy for coping with production uncertainties

Abstract The soaring demand for natural gas and deteriorating environmental conditions in recent years have together created a significant incentive for China to develop shale gas exploration. In this endeavor, production capacity is a major uncertainty that substantially affects the net investment return. We propose a Markov decision process model to explore and determine the desirable investment strategy under such uncertainty. Our model has the advantage of being able to handle dynamic stochastic market states, and it considers not only the value of the project itself (net cash flow) but also the social welfare, environmental cost, and financial subsidy. Our objective is to maximize the long run expected return of investment. The methodology was applied to determine the investment strategy for a case study in China. We found that the project is feasible only when the production capacity is larger than 8.55 billion cubic meters. Additional shale gas supply may generate higher sales revenue. However, the benefits may be neutralized by the decrease in price when domestic demand is inelastic to price. We also found that financial subsidy is an effective incentive for shale gas investment because it significantly increases the expected return of investment.