Moles, Peter

Constantinou, Charalambos

Kretzschmar, Gavin Lee

2007-08-03T08:10:44Z

2007-08-03T08:10:44Z

2005

Real option and dynamic asset valuation techniques are becoming established as standard methods for evaluating investment decisions that are subject to quantifiable uncertainty. This has been particularly the case in natural resources industries. In the UK oil industry there is renewed interest in oilfield valuation techniques - the 22nd UK Offshore Licensing Round was held in 2004 with a total of 97 licences offered to 58 companies in 2004, of which 15 were new entrants to the UK Continental Shelf. Many firms involved in these bid processes now routinely use dynamic modelling and real option valuation to assess oilfield value premiums in differing operating and taxation enviroments. Literature on PV and real option valuation is clear that models should accommodate tax effects but is unclear about its universal treatment in dynamic models. We examine the impact of the North Sea oil industry’s tax regime on the valuation of shelf real options by using a sample of forty oil fields that for the period 1970 to 2001 had initial estimated reserves greater than 75 million barrels of oil. Our sample uses Wood Mackenzie primary source field data updated quarterly by analysts using bottom up field research. Our findings are that the tax enviroment of itself will cause asymmetrical movements in both free cash flow models and option values. These results are of interest to both academics and practitioners in that that tax plays an important role in the valuation process of real options in the oil and gas sector. Our results show that North Sea valuation models that treat taxation as a deterministic function systematically overstate DCF valuation results, understate volatility estimates and undervalue real options. Specifically our analysis suggests that failure to incorporate the variable nature of tax into the valuation process leads to an 18 percent over valuation of asset PV and an under valuation of the option price by 19.5 percent. The increased usage of real option techniques in assessing oil field bids highlights the need for valuation models to incorporate the country specific nature of tax terms. This is especially important for oil fields in the North Sea where field exploration block bidding interest remains high and the legacy of tax changes is long; demanding from financiers a new way of assessing bid values in the face of future cash flow uncertainty. Key words: real option valuation, volatility, taxation JEL classification: G12; G31

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Management School and Economics. The University of Edinburgh

CFMR

05.01

Economics

Taxation and Volatility Effects on Real Option Models: A Study of North Sea Oil Fields

Working Paper