Jack up 2009 Conference – City University 15-16 September 2009 1 REAL OPTION APPROACH FOR JACK UP VALUATION Sirous Yasseri, KBR Energy and Chemical, UK R. B. Mahani, Morgan Oil Ltd, UK Abstract Successful investing in oil and gas offshore projects is highly dependent on technology and market conditions. A pivotal aim of an investor is to allocate resources to financially rewarding projects. In order to identify value-increasing projects, companies perform the discounted cash flow method or the more advanced decision tree analyses. These methods, however, cannot properly capture the value of the flexibility to re-adjust plans to possible external and internal "shocks". Moreover, traditional valuation tools give no insight about how these future decision contingencies affect the risk of a project during its lifetime. The real option approach may help to solve these problems, and provide an insightful investment decision framework. The objective of this paper is to demonstrate how the real option approach can be practically applied to the investment decision making in jack ups, accounting for flexibility, strategic growth opportunities and idle time. The suitability of real option valuation for investment decision making is also discussed. Key Words Jack up, Drilling, Real Options, Investment Analysis, DCF, NPV, Oil and Gas, Project evaluation Nomenclatures y option expiration time in years u up movement factor of the underlying asset N quantity of tree steps d down movement factor of the underlying asset r Risk free interest rate per year NPV Net Present value σ project volatility DCF Discounted Cash Flow b dividends rate S Price p up movement probability X Exercise price 1. Introduction The offshore drilling operation is complex, and the cost per day of a drilling rig (the day-rate) varies as a function of market conditions governed by crude oil price and the water depth. Additional factors are cost of rig acquisition, manpower, regulations (safety, environment and certification) as well partnership formation. A drilling company acquires or constructs a unit and, in general, receives day-rate remuneration from the prospector which leases the rig. In some cases receives an incentive bonus for operational performance or high equipments availability. Also, there are turn-key contracts in which a fixed value is received for drilling a well, irrespective of duration; but this practice is not common, as it could lead to priority in operational speed and not in well quality. The remuneration value is affected by economic uncertainty (motion of market influencing prices) or by technical uncertainty (new technologies, obsolescence, new contract types and performance of newly-installed equipments). The drilling rig is depreciated by use and by maintenance needs; and the technological development may render it less competitive. The volatility of day-rate is very high, suggesting that economic evaluations based on NPV (net present value) are inadequate. Some companies support periods of negative cash flow in expectation of the situation reversal. In general the rig operating cost is almost constant, as the asset depreciation is a very significant contributing factor. Decisions about drilling rig acquisition or its sale, operation interruption or reactivation, avoiding inopportune attitudes and available time to exercise such options, require considerable managerial flexibility and almost always such decisions are irreversible ones. For investment or re-entry the more significant variables are: acquisition cost, operating cost, volatility and discount rates (net and risk-free) and, at a lower level, the abandonment cost. For reactivation and temporary stoppage, the operational and maintenance costs are the main influences. With a smaller impact, the lump-sum costs for suspension and reactivation and the volatility.