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This paper presents a practical approach to project evaluation using techniques of modem financial economics, with a sample application to oil development under a complex tax system. The method overcomes shortcomings of conventional DCF methods which are either imprecise about the relation between economic value and uncertainty, or are rigid and unrealistic in the required assumptions about how a project's risks (and therefore its value) are influenced by market conditions, the project physical structure, and tax and contract provisions. It is based on the formulation and estimation of an "information model" which represents the resolution over time of uncertainties underlying a project (oil prices in the examples shown). The project can then be valued using derivative asset valuation, which replicates the consequences of a complex asset by a traded portfolio of simpler assets (in our case, riskless bonds and future claims on oil).

This paper is the third in a series that describes how Modern Asset Pricing (MAP) may be used for project evaluation in the upstream petroleum industry. It demonstrates how MAP can be applied to projects where policies for the management of future flexibility must be considered within the context of the valuation. We illustrate this use of MAP by looking specifically at flexibility in the timing of the exploration, delineation, and development of an oil prospect, and the timing of the abandonment of the subsequent developed field. We use examples to show how the value and management of flexibility depends on the amount of oil price and reserve size uncertainty. We find that prospect value increases with both types of uncertainty. We also find that all actions, from exploration to abandonment, occur later with greater oil price uncertainty. Conversely, we find that exploration and delineation occur sooner with greater reserve uncertainty. The reasons for these results are given.

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