Estimation of volatility of selected oil production projects Gabriel A. Costa Lima 1 , Saul B. Suslick ⁎ Center of Petroleum Studies (CEPETRO/UNICAMP) and Institute of Geosciences of State University of Campinas (UNICAMP), Brazil Received 29 December 2005; received in revised form 12 July 2006; accepted 13 July 2006 Abstract In oil project valuation and investment decision-making, volatility is a key parameter, but it is difficult to estimate. From a traditional investment viewpoint, volatility reduces project value because it increases its discount rate via a higher risk premium. Contrarily, according to the real-option pricing theory, volatility may aggregate value to the project, since the downside potential is limited whereas the upside is theoretically unbounded. However, the estimation of project volatility is very complicated since there is not a historical series of project values. In such cases, many analysts assume that oil price volatility is equal to that of project. In order to overcome such problems, in this paper an alternative numerical method based on present value of future cash flows and Monte Carlo simulation is proposed to estimate the volatility of projects. This method is applied to estimate the volatility of 12 deep-water offshore oil projects considering that oil price will evolve according to one of two stochastic processes: Geometric Brownian Motion and Mean-Reverting Motion. Results indicate that the volatility of commodity usually undervalue that of project. For the set of offshore projects analyzed in this paper, project volatility is at least 79% higher than that of oil prices and increases dramatically in those cases of high capital expenditures and low price. © 2006 Elsevier B.V. All rights reserved. Keywords: Uncertainty; Volatility; Real options; Oil projects; Economic evaluation methods 1. Introduction The option pricing theory has been widely used in valuation of managerial flexibilities and decision- making associated with investments in projects (Dixit and Pindyck, 1994; Trigeorgis, 1996; Copeland and Antikarov, 2001). In the petroleum industry, results of this theory are superior to those of traditional net present value (NPV) since they consider three important char- acteristics of many projects: • that many investments are at least in part irreversible, that is, in the case of an unsuccessful venture, the corporation cannot recover its investment by selling off its physical and intangible assets; • that the uncertainty in future values of components of cash flow may aggregate value to the project, rather than the traditional view in which future uncertainty reduces NPV because of a higher risk premium of the discount rate; • that the possibility of future uncertainty to aggregate value to projects takes place since managers have flexibilities or managerial options to take advantages of favorable motions of price, production, demand, cost, etc. In projects where there are managerial flexibilities such as postponement of the project startup, expansion or contraction of production, operation abandonment, among others, the traditional theory of NPV undervalues Journal of Petroleum Science and Engineering 54 (2006) 129 – 139 www.elsevier.com/locate/petrol ⁎ Corresponding author. Tel.: +55 19 3788 4661. E-mail addresses: gabriel@ige.unicamp.br (G.A. Costa Lima), suslick@ige.unicamp.br (S.B. Suslick). 1 Tel.: +55 19 3788 5157; fax: +55 19 3289 4916. 0920-4105/$ - see front matter © 2006 Elsevier B.V. All rights reserved. doi:10.1016/j.petrol.2006.07.005