Valuation of extension options on offshore rig contracts on the NCS

Abstract

Offshore rigs are a necessary tool in exploration and development projects in the oil and gas industry. The offshore rig market is unique in the way that the majority of the rig fleet is owned by independent rig firms and leased to oil and gas operators. Despite the substantial economic scope of this sector, the research on the offshore rig market has been limited. The purpose of this paper is to investigate a special aspect in the contracts between a rig owner and an oil operator - an option to extend the initial drilling period. This option gives the operator flexibility and a potential financial upside. By using option theory, we wish to examine the financial value these options represent and how this value is affected by whether the market is tight or soft. We also wish to investigate what challenges the use of extension options present. The findings in our analysis proves that a one-well-option embedded in drilling contracts represents a substantial financial value. The financial value of the option will vary among different types of rigs and different market conditions. In addition, our research suggests that options offer invaluable flexibility, but also present challenges of unpredictability surrounding future expected rig rates and rig commitment.