(This article discusses how to determine the appropriate value of signature bonus and firm commitment in the bid proposal for block tender. This article had been presented in Indonesian Petroleum Association (IPA) Conference, session 15, date 19 May 2011 at 08.00 am, kakatua Room, Jakarta Convention Center)

The Indonesian Government has set itself an ambitious target to increase oil and gas production by 2010. The Government recognizes that in order to achieve this goal in an environment of diminishing production from declining mature fields and increasing global competition, it must continue taking steps to improve the fiscal terms available to investors in order to encourage further exploration and investment in Indonesia’s petroleum industry.

Currently, there are two principal mechanisms for awarding blocks in Indonesia, i.e.: Regular Tender and Direct Offer.

In the process of block tendering, each contractor should submit a competitive bidding proposal to the government. Parameters considered most critical by the government are the commitment program and amount of signature bonus offered

Figure 1 showed the total amount of signature bonus and firm investment committed by tender winners for the 2001 – 2010 period.

**Figure 1: Signature Bonus and Investment Commitment for 2001 – 2010 period
(source: Migas)**

*exclude 2nd Petroleum Bidding Round 2010

Data for 2007 is interesting as it highlights the fact that even though the number of contracts signed in 2007 was lower than that for 2008, the total amount of signature bonus and firm investment commitment was higher.

This anomaly happened because there was a high bid value for one block in the 2007 bidding. This block was very attractive for investor due to potentially gigantic gas resource. The signature bonus of $ 40 million was paid and firm investment of $143 million was committed by the tender winner.

Looking at some bidding process, we are sometimes confused as to what is a reasonable value in a given oil and gas tender and how we justify that value.

This situation confirms our belief that investors require guidance in determining the total value of a signature bonus and commitment program for bidding blocks in Indonesia.

**Modern Valuation for Valuing Unexplored Reserve
**

Currently, the economics evaluation on the unexplored block is based on a combination of Net Present Value (NPV) and Probability of Geological Success (Pg). This approach requires the assumption of production profile and development cost schedule that in some cases is very difficult to get from the unexplored blocks.

The criteria for the NPV approach implicitly assume that no possibilities exist for the delay of any investment costs. In this regard investment must be treated as a “Now or Never” decision. However, in practice, investment can be delayed in order to obtain more information on the variables that are to determine project profitability (Pindyck, 1991 and 1995). Therefore, the decision concerning when to invest should compare the project values of an immediate investment against all possible investment points in the future. The advance study covering this subject is known as Real Options (RO)

The first application of Real Options to value undeveloped reserves was introduced in the seminal work of Paddock, Siegel, and Smith during 1987-1988.

The detail of Paddock Siegel Smith Model had been discussed previously as seen at this address: http://explorerealoptions.com/partial-differential-equation-pde-approach-in-real-option-valuation/

As shown in Figure 2, the threshold price will determine the critical value at which it is optimal to invest

**Figure 2: Optimal Rule of Investment Decision
(Pindyck, 1991)**

An investor will only invest if the investment they intend to make has a sufficient rate of return. However, in addition to the above another factor is the uncertainty and this must be considered when making decisions about projects. This means that there is a “threshold price” and this is an integral part of making an optimal investment. Therefore, as uncertainty increases, so does the threshold price and if the value of the project is less than the threshold price then investors will hold off on making their investment.

**Determine appropriate value of signature Bonus and Firm Commitment in Bid proposal**

The key principle in creating bidding strategies is to how add value to the company, not just to win the block.

Due to the uncertainty in estimating volume, chance and value, whenever there are many bidders, almost invariably someone will unknowingly overestimate the attractiveness of a block offered under sealed bid and will pay too much for the block (“winner’s curse”).

Based on the study of three employees of ARCO (Edward Capen, Robert Clapp, and William Campbell) in 1971, they noticed in the bidding for offshore drilling rights in the US, oil companies often seem to pay more than the block turned out to be worth.

Based on their observation in ARCO, they suggested that the optimal bid level for balancing these opposing factors was 35% of the EMV of the block as seen in figure 3.

**Figure 3: Optimal Bid level**

To get the appropriate bid level, we should refer to the level uncertainty in our assessment of the volumes, chance and value of the block. The magnitude of the bid level is proportional to the uncertainty associated with the estimation of value for the prospect or property. As uncertainty increases, increase the depth of discount (low bid level).

For example, for high risk ventures in an under explored international basin, 20% – 30% may be appropriate; for low uncertainty offerings (e.g., an exploitation opportunity) where you anticipate a high level of competition, your company may need to bid 50 – 75% of the EMV.

**Case Study**

In this case study, we would evaluate a prospect (block X) that was tendered in Dec 2007. This prospect is estimated a potential gas resource of 5-15 TCF. Term Conditions applied on this prospect is as follows:

- split after tax: 65:35 (oil) and 60:40 (gas)
- minimum signature bonus: $ 5 million

As this prospect is still in the exploration stage, there is uncertain to discover gas. We assumed the probability of geological success (Pg) is 15%.

There are three case scenarios of reserve for this evaluation, i.e.:

1. P90 = 5 TCF (worst case)

2. P50 = 10 TCF (base case)

3. P10 = 15 TCF (best case)

Using the combination of PSS model calculation and a study of Capen et all, we would determine the total value of signature bonus and investment commitment for bid submission on this prospect.

**Data Assumption**

As this prospect has a high potential gas resource, we assumed this prospect will be developed to support LNG project. Using this development scenario, we can use benchmark cost data of similar LNG project in Indonesia. Table 1 shows the data assumption of this prospect.

**Table 1: Data Assumption for Block X**

We follow the reasonable assumption that the appropriate measure of development costs is the present value (PV) of real after-tax development expenditures.

Based on the benchmark data, the upstream capital expenditure for LNG project is $0.27/boe for monetizing gas of 10 TCF reserve. As intangible development expenditure can be expensed for tax purposes, the result of PV development after tax for each scenario can be seen in the table 2.

**Table 2: Development Cost after Tax**

Depreciation allowances for tangible development expenditures and contractor share are associated with developed reserves price and would be included in that value.

Based on the futures market data in the end of 2007, we can estimate the payout rate of the project using equation 8. The futures contract for oil delivered in Jan 2008 is quoted at $81.93/bbl and the April contract at $80.01/bbl. The net holding cost, h, is then -2.3% over that three-month period, or -9.4% on an annualized basis. If risk free rate is assumed to be 5%, then the estimate of pay our rate (?? would be [5.0 – (-9.4.0)] = 14.4%.

We also considered time lag during the development stage. While in the case of a call option the stock is ideally delivered at the same time as the payment of the exercise price, in the case of an undeveloped oil reserve after the decision is taken it takes a certain amount of time develop it and hence the time lag. Thus there is a lag between the decision to develop the reserve (to exercise the development option) and the actual payoff arising from oil production.

Based on the reserve transaction in Indonesia in the end 2007 and early 2008 for the similar block, the transaction was deal in $0.80/mmscf. This was a sufficiently reliable estimate for developed reserves price. This market value of developed reserve (mvdr) is then discounted for this development lag of 2 years (t) and we found the prospect Value (V) = = 0.6/mmscf. This result would be compared to the threshold price for each scenario of reserve (see table 3).

The volatility parameter is assumed and taken from the annual standard deviation of rate of change of oil price equal to 34%. Risk free rate is assumed to be 5%.

**Paddock Siegel Smith Model Calculation**

The first set of results reflects the price per mmscf of the fields at each of their different reserve scenario. Table 4 reports development options value for each scenario at the end of 2007. As seen in the scenario of P50 and P10 reserve, the prospect value goes above this threshold price it is the optimal time to exercise the option and get to the next stage of development.

**Table 3: Development Option Value for Block X**

However, in the scenario of P90 reserve, threshold price of this prospect ($ 0.641/mmscf) is still higher than prospect value ($0.600/mmscf). It is less likely to be subject to immediate development.

If this condition is happened in the future, government may introduce an investment credits as an incentive to reduce the threshold price of the prospect.

Determining the threshold price of the project can be a good starting point for any negotiation between the government and the contractor, particularly in terms of seeking to accelerate the development of the PSC projects. The determination of the threshold price prior to the start of the bidding process would also allow the government to stipulate attractive PSC terms and conditions for potential investors.

The above result discusses the real option procedure to value undeveloped reserves where exploration has already taken place. We have calculated the value of the undeveloped reserves based on the assumption that we can choose to develop the reserves at any time prior to the expiration of the lease.

Since the prospect of block X is still in the exploration stage, we should incorporate the probability of geological success (Pg) into this valuation by taking the “hold value” from the results of the development options even though this value is higher than the threshold price.

This is the exact position if an exploration program has to be run where oil has to be found first before it can be developed. The reasons why the values of the exploration options are lower than development options are:

1. we have to pay exploration costs

2. we may not be able to exercise development option at what would otherwise be the optimal time

3. we introduce the possibility that exploration might not be successful.

Acquiring the Development Option Value (DOV) is one of the two possible outcomes from an exploration program. The other possibility is a dry hole.

To find the Exploration Option Value (EOV) with exploration period of three years (t), we assumed the probability of geological success is fixed independently of the amount of exploration expenditure.

Table 4 shows the result of exploration option value for each scenario.

**Table 4: Exploration Option Value for Block X**

To find the maximum amount that should be committed to an exploration program (Cmax), we would multiply a certain bid level.

In this case, we applied bid level of 20% as seen the result in the table 5. This is the maximum amount paid to this block in terms of signature bonus and exploration investment commitment.

**Table 5: Total Value of Signature Bonus and Investment Commitment**

If signature bonus is B, investment commitment (I) calculated as follows

I = [EOV / (1- contractor share x intangible cost x tax)] – B.

Let’s say, we use the base case scenario (P50, 10 TCF reserve) as a basis evaluation for bidding this block.

As shown in table 5, if the maximum signature bonus is $ 40 million, the total investment commitment is $ 142 million. The total amount of $ 142 million would be spread for 3 year program for seismic and drilling activity in the bidding proposal.

**Conclusion**

We have extended the idea of pricing unexplored reserve in bid tender process of oil and gas block in Indonesia. We have provided an example of a case study by estimating the value of the unexplored reserves based on the Paddock Siegel Smith (PSS) model.

The result shows that the PSS model can be used to justify the total value of signature bonus and investment commitment that would be proposed in the bidding proposal.

The results reported in this paper are preliminary, pending a careful statistical examination of the robustness of the valuation procedure.

This paper concludes that the PSS model can be applied in Indonesia to give guidance for investor to bid the block in the tender process.

As such, it has the potential to form the proper basis for any negotiation of contract terms between the contractor and the Government of Indonesia, particularly in terms of seeking to accelerate the development of the PSC projects.

Besides that, government can use this model to stipulate attractive PSC terms and conditions for potential investors.