Cost uncertainty in petroleum investments : a real options model

Abstract

There are a number of uncertainties that are important to consider when planning a large petroleum investment. Oil price uncertainty has, in particular, been incorporated in many examples of real options analyses of petroleum investments. However, in the context of real options, there are few academics or professionals who discuss cost uncertainty in the petroleum industry. This real options analysis on cost uncertainty in petroleum projects demonstrates that there are significant effects of introducing stochastic costs. We find that volatility and correlation between income and cost components have important effects on both option value and the optimal investment time, especially for projects that are initially less profitable. Moreover, the choice of convenience yield can magnify these effects. We conclude that although the analysis of these effects is tedious and computationally demanding, petroleum companies should consider incorporating a real options framework that includes cost uncertainty in their evaluations of future prospects.