Unlocking the Value of Real Options

In the early 1990s, Houston-based Anadarko Petroleum Corporation outbid competitors for the Tanzanite block in the Gulf of Mexico. It found oil and gas there in 1998 and was producing within three years. The Tanzanite discovery is significant not so much for an abundance of oil and gas, but that in bidding for it Anadarko broke with industry tradition. Rather than using only conventional discounted cash flow (DCF) to help it decide what the block was worth and how much to bid for the lease, the company opted for a new technique called real-options valuation (ROV). ROV gave Anadarko the confidence to outbid others because it suggested that there was more to Tanzanite than met the eye. Anadarko now routinely uses ROV when making investment decisions. Options embedded in, or attached to, physical or real assets are real options. These are distinct from options relating to financial assets—securities and other financial claims. ROV is a process by which a real or tangible asset with real uncertainties can be valued in a coherent manner when flexibility—or potential for options—is present. Most oil companies still use DCF to appraise potential investments. This method has served them well. Increasingly, however, companies are asking whether ROV might be used to complement DCF. ROV supporters argue that it gives a truer value than DCF only because the ROV model more closely reflects the variability and uncertainty in the world. ROV often can highlight extra value in projects, value that is possibly hidden or even invisible when DCF is used alone. Some companies that use ROV are reluctant to divulge parameter details of their models because of fears that revealing those details gives away a competitive advantage. ROV is not on the verge of displacing DCF. In fact, real-options valuation employs DCF as one of its tools. In practice, ROV combines and integrates the best of scenario planning, portfolio management, decision analysis and option pricing. This article reviews DCF and describes how ROV overcomes some, but not all, of its shortcomings. After explaining the parallels and differences between financial options and real options, it examines two of the many methods of valuing options, the Black-Scholes formula and binomial lattices. ROV is illustrated by a case study of a liquefied natural gas (LNG) transport option. A series of linked, synthetic examples describes several simple forms of binomial lattices.