Valuation of Oil Company using Real Options

November 12, 2009 • Tell FriendsPrinter Friendly

This article will discuss how real options can be used to determine the stock price of Oil Company listed in stock exchange. A hostile take-over of an oil company in 2004 will be used as a case study. A real options model from Paddock, Siegel, and Smith (PSS model) will be used to value undeveloped and unexplored reserves belonging to this company and determine stock price of this company based on the published data.

Case Background

An Oil Company (called: COY) listed in Australian Stock Exchange had a diversified portfolio of oil and gas assets in 7 countries.

The Independent Oil Company (called: IOC) attracted to the exploration upside of some of COY’s key Assets and viewed COY as a cost effective company. IOC was interested in acquiring this company in 2003.

case-storyOn December 2003, IOC started to submit an offering to COY management for A$ 1.74/share. The market price of COY in Stock Exchange on Dec 2003 was around A$ 1.52/share.

After IOC’s offering, there was an competitor from other oil company (called: COC) give an offer for A$ 1.77/share on January 2004. Although this offering was higher than IOC, COY rejected it because the consultant hired by COY had suggested that the value of COY should be in range of A$ 1.77 – 1.96 / share

On April 2004, COC raised their offering to A$ 1.85/share. Following this, IOC also raised their offering to A$ 1.9/share on May 2004.

On June 2004, the transaction was closed after no response from COC to increase the bid price. By the end of this month, COY’s shareholder agree to accept IOC’s offering at A$ 1.9 / share.
Some analysts said this acquisition price is too high since the average market stock price of COY on December 2003 was around A$1.52/share.

There are two questions came up of this case study, i.e.:

  1. What is the fair market value for COY’s stock price in 2003 year end?
  2. Is the closing price for AOC acquisition justified in the oil market situation at that time?

To get the fair market value, we will use the market information regarding the actual reserve price that had been transacted in the last 10 years. This information would be taken from study of Adelman and Watkins in 2005. They studied the estimate average price of actual reserve transaction price in US for period of 1986 – 2003. The results is shown in the below graph.


Based on the above graph, the average transaction price of oil and gas reserve in 2003 is US$ 8.17/bbl. This price would be use as a barrel value of developed reserve in PSS model.

Paddock Siegel and Smith (PSS) model

The real options model used to value the COY reserve is the numeric model from Paddock Siegel and Smiths published in(1988). The model doesn’t require the profile production and development schedule from each asset of COY as we normally do in the DCF valuation.
The model will calculate all the parameter based on unit value of $/bbl.

The PSS model is as follows:


Pyndick on his paper in 1991 solve the PSS model as follows:


V* = Threshold Price when the project is optimal to be exercise
I = Development Cost

For detail steps in how to derive the above solution, see other article in this website.

COY Reserve Valuation

There will be three categories of reserve, i.e.:

  1. Proved and developed reserve (producing field)
  2. Proved and Undeveloped reserve
  3. Probable reserve

For category 1 (developed and producing reserves), we can use the traditional DCF as this reserve already in production flow and generate cash flow.
The Table below summarizes the producing reserve value based on the free cash flow generated by COY in the end of 2003.


We assumed the required rate of return on COY’ assets is 17%. To get the cumulative NPV of producing reserves, future net cash flows from existing producing reserves are assumed to follow an exponential decline over time whose annual rate is 15%.
Under these assumptions the PV of future cash flows arising from existing operations is given by:
NPV(producing reserves) = NCF / (1 – exp[-(d + u)])

where d = 15% is the average annual decline rate, and u = 17% is the required annual rate of return on COY’s assets, and NCF is the 2003 net cash flow.

The value of developed producing reserves is A$ 40 millions

For reserve category 2 and 3, we will use the PSS model to calculate the development option and exploration option.

Based on the reserve status in 2003 year end, the COY had data as follows:


Note: Gas is converted to oil equivalent based on a conversion factor of 6,000 cf / bbl.

Based on the historical cost of exploration, development and production on each area of COC assets, the value of each parameter in PSS model would be assumed as follows (in US$/bbl):


The result of PSS calculation from the above data will be categorized in two options value, i.e. development options for undeveloped reserve and exploration options for probable reserve as seen in the below table (in Aus$ with exchange rate = 0.76 US$/Aus$).

The value of undeveloped reserves is A$ 385.9 millions and value of probable reserves is 42.9.

The total of EOY assets from three categories of reserves is as follows (A$ million):

1. Proved and developed reserve (producing field) :   40.0
2. Proved and Undeveloped reserve                              : 385.9
3. Probable reserve                                                                :    42.9
Total Value : 469.2

Based on the balance sheet status of Dec 31st, 2003 and total value estimate of COY’s reserves, the fair market value (FMV) of COY’s stock price is A$ 1.62/share, as seen in the below table.


This FMV price of A$ 1.61/share is higher than actual average of Dec’2003 stock price i.e. A$ 1.52/share. This difference could be an indicator of the existence of managerial inefficiencies within COY. We interpret the extra 6% value found by real options methodology as being consistent with some degree of managerial inefficiencies of COY at the end of 2003. It could be other fact, why COY would then be subject to a hostile takeover bid a few months into 2004. This fact follow the traditional view of corporate financial theory suggesting that take-over attempts are disciplinary devices targeting firms with inefficient management.

From this result, we have found the fair market value of COY stock price on Dec 2003 i.e. A$ 1.61/share. This result has answered the question no 1

To answer question no 2 about the acquisition price of A$ 1.9/share, is it reasonable?

As seen in the below table using the same procedure , if the stock price is A$ 1.90/share, the net back value of developed reserve is US$8.50 per barrel. It’s a little bit higher with the previous calculation that used US$8.17 based on study from Adelman & Watkins.
Looking the difference assumption of value of developed reserve, it is quite reasonable for IOC to acquire COY at A$ 1.90/share since the oil price tend to going up in 2004.


Using RO approach, we can determine the stock price of listed oil company based on fair market value and justify the reasonable price for acquiring the listed oil company

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