Monte Carlo Evaluation Model of an Undeveloped Oil Field C O NZA LO C O RTA ZA R Pa n tific ia Universidad Catolica de Chile EDUA RDO S. SC HWA RTZ* Unive rsity of California at LosAngeles ABSTRACT In this article we develop and implement a model to value an undevel- oped oil field and to determine the optimal timing of investment. We assume a two fac- tor model for the stochastic behavior of oil prices for which a closed form solution for futures prices can be obtained. The advantage of this model is that it allows for the term structure of futures prices to be upward sloping (contango), downward sloping (back- wardation) and also humped. We use Monte Carlo simulation methods for solving the problem. Since the decision to develop the oil field can be taken at any time until the expiration of the concession, the option to invest is of the American type. This type of options are solved by the numerical solution of the appropriate partial differential equa- tion. If we assume, however, that the decision to invest (exercise the option) can be made at a tin&e number of points in time instead of continuously, the problem can be solved using simulation methods. Apart from being more intuitive, Monte Carlo simu- lation methods easily allow for the consideration of many additional random variables such as costs, amount of reserves, etc. I. INTRODUCTION An undeveloped oil field has value because it might be developed someday and their oil production sold. The determination of the value that someone would be willing to pay to *Direct all correspondence to: Eduardo S. Schwartz, The Anderson School of Management, UCLA, 110 West- wood Plaza, Suite C409, Box 95148, Los Angeles, CA 90095-1481. Jownal of Energy Finance & Development, Volume 3, Number 1, pages 73-84. Copyright 0 1998 by JAI Press Inc. AU rights of reproduction in any form reserved ISSN: 1085.7443