Valuing Pud Reserves: a Practical Application of Real Option Techniques

he oil industry was among the first of the large industries both to adopt discounted cash flow methods in valuing assets and projects. Discounted cash flow (DCF) tools are fundamental to engineering and financial analysis in the oil industry. They are well understood by managers and generally provide accurate valuations of developed hydrocarbon reserves. Unfortunately, DCF techniques systematically undervalue undeveloped reserves. Moreover, they may encourage premature development of certain reserves, and may also fail to identify important risk management opportunities. Managers in the oil industry have long been aware that the market value of individual oil properties, not to mention entire E&P companies, is usually greater than the value of their discounted cash flows.1 This is particularly true in cases where there are significant quantities of undeveloped reserves. For this reason, E&P managers have often been willing to pay a premium above a DCF value for some undefinable “upside” associated with undeveloped reserves. Unfortunately, the analytical discipline usually imposed by the DCF method is lost when managers value properties or companies on the basis of rules-ofthumb or simple intuition. Real option models address these shortcomings. Though more complex than traditional DCF analysis, real option models provide a far more complete picture of not only reserve values but also the drivers of that value. Proven undeveloped reserves (PUDs) lend themselves to real option analysis because owners of PUDs have the right, but not the obligation, to develop those reserves in the future, so that the total value of a PUD includes both a DCF value plus some additional option or “volatility” value. There is a sound economic reason to assess undeveloped reserves at more than their DCF value, and real options models provide the means to do so. T