The real option framework has received much academic attention, but does at the moment not look like a real competitor to traditional dcf-analysis. Important reasons for this are practical challenges related to the application of the method. This section discusses the practicability of the two methods on the grounds of experience obtained from the valuation of Goliat. The application of dcf-analysis in its traditional form is relative straightforward, and does not involve any particular practical challenges. As a result, the discussion regarding practical challenges will mostly relate to the real option method. Practical challenges related to evaluation of uncertainty and dcf-analysis is discussed in section 8.3.
8.2.1 Modeling expertise
Modeling and valuation of real options are quite different from traditional dcf-analysis. Dcf- analysis has great traditions and represents the standard of capital budgeting. The methodology of valuing a project by traditional dcf-analysis is widely recognized and well understood. The methodology of real options does not have the same status, and is not widely recognized and not well understood. This insight is supported by Booth (1999), stating that: “Real options are usually more complex still and the modelling expertise involved is substantial”. In their paper, Laughton, Sagi and Samis (2002) state that future developments in modern asset pricing (real options) are needed on among other key fronts: More efficient
and easily used computational methods; and more and better training and operational tools for implementation of modern asset pricing methods into real organizations.
The real option framework used in the case study of Goliat can be regarded as basic and simple. More technical advanced models exist. Application of state of the art real option modeling and valuation requires a high degree of modeling expertise. This knowledge must be made more accessible through education and training tools. In addition, development of software able to make computational issues easier is necessary. According to Laughton, Sagi and Samis, it took at least 80 years to sort out dcf-analysis and make its use widespread. It is likely to take a shorter, but still significant, time to sort out real options.
8.2.2 Complexity
It is desired to work with as short time periods as possible in the multiplicative binomial process, aiming at reaching a continuous distribution of possible project values. The realism of the stochastic process in real options increases as the length of binomial time periods are made shorter. A drawback of binomial trees is that they grow large and complex as time periods are made shorter. The case study confirms this difficulty. The binomial trees would grow extremely large in order to give the stochastic variable in the case study a continuous distribution.
Modeling and valuing real options requires detailed information about real options involved. This represented a big problem in the case study. The option to expand involves high uncertainty with regard to capex, opex and total amount of extractable reserves. Companies facing an actual or a possible option need detailed information about the characteristics of the option in order to make an accurate and applicable valuation. This information may not be possible to obtain at the time where decisions regarding development are to be made. The option to abandon involves high uncertainty with regard to the market value of facilities and equipment. Due to uncertainty with regards to liquidation and shutting down, it may the case that the option to abandon will generate a negative cash flow. This conflicts with the assumption taken in the case study, where Eni Norge is assumed to realize MNOK 800 due to a sale of facilities and equipment within six years of production. The assumptions regarding the option to expand and abandon has been invented by the author and has no link to real life.
Another practical (and theoretical) challenge involves consideration of option interaction. Three real options have been modeled and valued in the case study of Goliat. The NPVs of the options have been obtained valuing the options individually. An expected project value combining the base case and a real option have been found on the three real options respectively. The analysis does not consider the combined value of the three options. In real life, however, the total expected project NPV should incorporate the value of all possible options. As a consequence, there should be a way of combining the value of all options into one expected project NPV. A possible way of doing this would be to follow the principle of NPV-additivity, and summarize the excessive NPVs from the real options to the base case of the dcf-analysis. This would mean that the value of all real options would be added to the base case. The probability of management to realize all real options in Goliat seem unrealistic. If market conditions are good, the abandonment option will not be realized. If market conditions are bad, the expansion option will not be exercised. As a consequence, not all value related to the real options considered will be realized. This leads to the question about the correctness of incorporating all real option values into one expected project value. It seems that valuations of various individual real options are difficult to incorporate into one combined NPV. A correct real option project valuation would require all possible real options to be considered. This represents both a practical and theoretical challenge that needs more research and investigation.
Another practical challenge involves identifying all possible real options. Goliat may have an unlimited number of real options attached. These options may or may not be known at the point of time when valuation is performed. A valuation should consider all options, not just the option to wait, expand and abandon. Practical challenges of identifying and modeling all possible real options are substantial. In addition, the complexity of the valuation increases as more options are considered.
The practical challenges described above may make decision makers view real option valuation as a black box. The method does not seem developed enough to be a stand alone valuation method for oil and gas field developments. Information obtained from three oil companies supports these findings. The logic seems clear and well understood, but the real option method is not used in practice. In general, the three oil companies explain their reluctance to use real option analysis by better knowledge and traditions of traditional dcf- analysis, and practical challenges related to real options.
8.2.3 Organizational issues
The introduction of a new valuation method is recognized by a cost-benefit trade off. The choice of incorporating a real option framework for valuation requires investments and resources in terms of development of the method, acquirement of software and operational tools and training. Effort should be made in making results and the logic of real options easy to communicate and easy to understand. The aim and benefit of the introduction should be better investment decisions. Companies should analyze the environment they operate in, and the possible costs and benefits of introducing a new valuation method. Considering the already mentioned practical challenges, and the earlier described assumptions that must hold in order to justify a risk free valuation, the real option method may not be ready to be introduced for real life organizations and applications quite yet.