Real Options Analysis of Oil and Gas Resource Development for Independent E&P Firms in the North America

Abstract

Since the beginning of the global oil crisis in the mid-2000s, oil and gas prices have been more volatile than other commodity prices. Accordingly, it is increasingly important for the independent E&P companies that are relatively vulnerable to market uncertainty to choose appropriate additional reserves of oil and gas. This paper provides a real options framework for analyzing the reserve replacement decisions of independent E&P companies, considering uncertain revenues and irreversible costs. The model considers the extraction cost per unit well associated with the remaining reserve level per well and instant production. Focusing on the North American E&P companies, threshold levels of oil and gas prices are identified for economic feasibility, above which it is optimal to undertake investment for reserve additions. The results indicate that the relative gains from gas E&P projects are steadily decreasing, primarily because of lowered gas prices triggered by recent gas development booms in the North America. The policy implications from this finding support a more conservative strategy and increased attempts in the field of gas development projects.