Options in the real world: Lessons learned in evaluating oil and gas investments

Many firms in the oil and gas business have long used decision analysis techniques to evaluate exploration and development opportunities and have looked at recent development in option pricing theory as potentially offering improvements over the decision analysis approach. Unfortunately, it is difficult to discern the benefits of the options approach from the literature on the topic: Most of the published examples greatly oversimplify the kinds of projects encountered in practice, and comparisons are typically made to traditional discounted cash flow analysis, which, unlike the option pricing and decision analytic approaches, does not explicitly consider the uncertainty in project cash flows. In this paper, we provide a tutorial introduction to option pricing methods, focusing on how they relate to and can be integrated with decision analysis methods, and describe some lessons learned in using these methods to evaluate some real oil and gas investments.