Using Real Options Analysis For PSC Contract Term Negotiation

September 8, 2008 • Tell FriendsPrinter Friendly

(This article is summarized from paper that had been presented in 32nd IPA Annual Convention on May 27th, 2008, Jakarta Convention Centre, Merak Room 3, at 13.00-13.30)

Today, we have a challenge to increase oil and gas production in Indonesia as Government has set the target of 1.034 MBOPD for oil and 1,169 MBOEPD for gas in 2008. There are some efforts to meet this target i.e. optimizing the existing production field using intensively advance technology such as EOR, accelerating new development field, and encouraging exploration activity to discover new reserve.

To support the exploration activity in the unexplored area in Indonesia,, since 2002 government actively opens tender of new PSC blocks. As shown in the below figure, only below 50% of total blocks offered that had been signed in the following year. The interesting data is what occurred in 2006 when oil price was relatively high around $65/bbl, only 5 contracts was signed in 2006. It seems that the level of uncertainty was growing in 2006 due to uncertainties of cold weather in parts of Asia, Europe and US h and oil supplies from Nigeria, Iran and Iraq. This condition resulted many investors at that time waited until uncertainty resolved before undertaking the necessary investment. As uncertainty reduced specially for the level of oil price, in 2007, investors started investing in Indonesia as reflected by 26 PSC contract signed in 2007. It seemed that in 2007 investors looked at the oil market had the new level of price equilibrium because supply and demand for crude in market had been stretched for several years.

Figure 1. Blocks Offered, Signed and Signature Bonus for 2000 – 2007 period
(Source : Ditjend Migas)

These above fact open our insights that besides the cost that investor invest as well as the pay out rate that investor wants to get, there is another factor i.e. uncertainty that should be considered in making decision on the project. In other words, there is a “threshold price” that investor will invest optimally. As uncertainty increases, threshold price will increase. If a project value does not exceed the threshold price, investors prefer to wait before they decide to invest.

Determining the threshold price of the project can be a good starting point for negotiation between government and contractor to accelerate the development of the PSC projects and also for PSC contract extensions. In part of the bidding process, government can also use this approach to set an attractive PSC contract term for investor.


Currently, the economics criteria for negotiation are still based on the DCF result. However, this methodology is failed to find the threshold price that the project can be invested immediately considering the effect of uncertainty surrounding the value of investment.
Real Options is an alternative methodology that can find this threshold price that considered factor of development cost, pay our rate and also the uncertainty level.

Following Paddock, Siegel and Smith (1988) real option approach, we extend their approach to value unexplored reserves in Indonesia and propose the adaptation of the above parameters into Indonesian PSC regime.

Two parameters that we can adapt into PSC regime are as follows:

1. PV of Development Cost

PV of Development cost is taken from after tax deduction of intangible drilling cost since this cost can be expensed for tax purposes. In PSC regime, the factor of contractor share should also be considered because cost occurred in PSC basically will affect contractors as much as their split shares.

DevCost afer tax = DevCost-(% Intangible Expense*DevCost*Contractor share*Tax)

2. Pay Out Rate

Following Paddock, Siegel and Smith (1988), we start by calculating the waiting opportunity cost ?, defined as follows:

?t: fraction of oil produced yearly ,
?t: net profit per barrel,
Wt: unit value of developed reserve (per barrel)

In the Indonesian PSC regime, the term of net profit (?t) of contractor is defined as contractor share split after tax. Any changes in oil price (Mt) will affect contractors as much as their “split share after tax”. The same application is also used for developed reserve value (Wt) where contractors just accrue as much as their “split share after tax”. Based on these adjustments, we define pay out rate, ? in PSC regime as follows:


To illustrate the valuation for unexplored reserve, we will use the case of the exploration block in PSC regime. Block Y had been awarded to Medco on October 2003 with contractor share after tax of 25%.
For comparison study, we use Block Z as the hypothetical sample that had the same contract term as Block Y.

Table 1.
Data Assumption for Block Y and Z

As shown in the above table, we see that block Y has more valuable than block Z since the chance of success and estimate reserve of Block Y if success is higher than block Z. The other thing, the development cost of block Y is lower than block Z.
In the end of 2003, the market oil price was at $25.00/bbl flat. Following Gruy and Wood (1982) that assumed that the developed reserve is one third of market crude price, we can estimate the pay out rate for each field. The results can be seen in the below table.

Table 2
Pay Out Rate for Block Y and Z

Let’s assumed the volatility and risk free interest rate are at 34% and 5% respectively, the value of development option if these reserves are success to be discovered as shown in the below table.

Table 3
Value of Development Option for Block Y and Z

From this table, it was confirmed that Block Y has a potential to be developed soon since project value is higher than threshold price. In contrary, Block Z has a higher threshold price than project value. Look at this situation; it was possible for government to give investment credit as an incentive for Block Y since the development cost is relatively high. Normally, investment credit is applied for facilities development.

Table 4
Optimal Investment Credit (IC) for Block Z

The break point of the project value exceeds threshold price if government give investment credit more than 60.1% as shown in the above table.

Table 5
Maximum Exploration Spending

The signature bonus paid for block Y was`$2.6 million and for block Z we assume we pay only $1 million. As shown in above table, the maximum exploration cost that can be spent in block Y is $38.36 MM. For Block Z, the maximum exploration cost is going up from $2.97 MM to 3.98 MM after government gives an investment credit. From this case, there is a signal that by giving an incentive to lower the threshold price, we can increase the opportunity to find the reserve with more exploration spending.


We have extended the idea of pricing unexplored reserves as options to the evaluation in the Indonesian PSC Regime. From the hypothetical study, it shows that real options method is a potential tool to form a proper basis for the negotiation of contract terms between the contractor and Government, as a result of which development of the undeveloped reserves in Indonesia can be stimulated.

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