The value of flexibility: Theory and practice The oil & gas- and the pharmaceutical industry

Transcription

1 The value of flexibility: Theory and practice The oil & gas- and the pharmaceutical industry 4 October 2012 Bart Willigers

2 This presentation provides a personal perspective of the author

3 The oil & gas industry and the pharmaceutical industry Similarities Differences High risk, staged investments Long payback periods Traditionally dominated by supermajors Commodity versus unique products Number of options to be considered given a development stage Available data for economic modelling Many smaller players are now entering the industry Stakeholder management is a key success factor Highly skilled, educated workforce 3

4 A pharmaceutical decision tree Phase 3 Block buster Commercial success Phase 2 Commercial failure Phase 1 Pre-clinical 4

5 An oil & gas decision tree Development High reserves outcome Mid reserves outcome Appraisal Low reserves outcome Exploration Bidding 5

6 Data available to decision makers Oil & gas Hydrocarbon prices Large amount of data Pharmaceutical Success rates for each development stage Duration of development stages Well defined criteria of success 6

7 The value flexibility Drill and Develop Oil No oil (Oil sales - platform cost)*probability (120-50)*50%=35 (0-50)*50%=-25 EMV=10 Drill Oil Develop? Build Walk (120-50)*50%=35 (0)*50%=0 EMV=35 Value of flexibility=25 No oil Develop? Build Walk (0-50)*50%=-25 (0-0)*50%=0 7

8 The value of flexibility Market penetration Outcome Phase 3 Stop-go launch Stop-go Phase 3 Exit decision Stop-go Phase 2 Outcome Phase 2 Exit decision Outcome Pre-clinical Stop-go Phase 1 Outcome Phase 1 Exit decision Exit decision 8

9 Value creation by capitalizing on the value creation Value can be created by creating project options Allow for flexibility until an uncertainty is resolved Relevant questions What are key uncertainties and when are they resolved? What are the most important future decisions? 9

10 Quantifying the value of flexibility The value of flexibility is generally modelled in decision trees Residual risks and associated flexibility can be easily modelled in decision trees Market risks and associated flexibility is hard to model in decision trees The straightforward application of discount rates and market scenarios can lead to erroneous results 10

11 Should we discount for market risk? (Oil sales - platform cost) Base oil price ( )=90 Build large Develop? (120-50)=70 Build small Value loss=20 or 28% Walk (0-0)=0 Low oil price Develop? ( )=50 Build large (100-50)=50 Build small Value loss=40 or 44% Walk (0-0)=0 11

12 Should we use price decks? Oil price ($/bll) Period (years) 12

13 The simulated outcome in 2011 is the P10 outcome Oil price ($/bll) Period (years) 13

14 Given the P10 outcome new probabilities need to be assigned to the price desks Oil price ($/bll) Period (years) 14

15 Or new post-2011 price desks can be developed Oil price ($/bll) Period (years) 15

16 Sampling from a continuous distribution Oil price ($/bll) Period (years)

17 Bayesian logic: New price desks reflect realised price in Oil price ($/bll) Period (years) 17

18 The post 2017 price desks Oil price ($/bll) Period (years)

19 Real options valuation Discounting using the risk free rate Opposed to address market risk in the discount rate market risk is modelled Updating point forward market view at future decision point Bayesian logic is embedded in stochastic price processes 19

20 Real options in practise...so if real option valuation appropriately models the value of flexibility......why is not everyone using real options valuation??? 20

21 Arguments against real options valuation The pharmaceutical industry and the oil&gas execute non-economic analyses with a much higher degree of complexities Scholes and Merton option valuation formulation is too Much progress has been made in stochastic modelling and simulation tools to solve real options problems Decision makers will react to events even these events cannot be controlled Private risks are frequently correlated with residual risks 21

22 Arguments against real options valuation Modelled decision logic versus actual decision making Modelled decision logic must align with actual decision making Modelling complexities More insights might be created by modelling aspects other than stochastic market uncertainty A consistent valuation method is needed when choosing from a portfolio of project options Added complexity makes communicating an analysis more difficult 22

23 Conclusions Pharmaceutical - and oil & gas projects share many characteristics The value of flexibility is an important value driver and should be captured in project valuation Decision trees can readily be used when analysing residual risks Market risks can be modelled using real option valuation Recent mathematical innovations allow for accurate valuation of very complex decision situations There are some valid practical considerations against the use of real option valuation 23

24 An example of real option valuation: Swing contracts in the oil & gas sector A swing contract holder can vary the quantity gas purchased in each period The contract holder to manage uncertainties The other party to the contract is obliged to supply the quantity demanded by the buyer. 24

25 later Should the single available swing option be exercised in period 2? 25

26 later If the option is exercised in period 2 the owner foregoes the option to capitalise on the higher gas prices in period 7 and 10 26

27 Number of swing options and contract value 27

28 Swing contract The holder of the swing contract aims to sell gas when gas prices are high Valuating a swing contract using the average gas price will undervalue the contract 28