The Optimal Investment Scale and Timing: A Real Option Approach to Oilfield Development

The oil company holds the investment opportunity to develop a delineated oilfield. The investment plan must be presented until a specific date or the oilfield rights return to the government. The firm considers a set of mutually exclusive alternatives of scale to exploit the oilfield. Larger scale means faster exploitation – increasing the present value of revenues, but also higher investment cost. Oil price uncertainty affects all alternatives. In addition to the scale option, the firm has a timing option and hence this investment opportunity is analog to a finite-lived American call option on the best of multiple assets with the same underlying oil price stochastic process but with different benefits and different exercise prices. We examine both geometric Brownian motion and a mean-reversion process to model oil prices. We obtain the undeveloped oilfield (real option) value and the optimal investment rules, i.e., the optimal timing and the optimal scale thresholds.