Decision making framework for investments in oil industry: An application of Real Options

Abstract

Uncertainty is one of the major challenges in any business enterprise. There is uncertainty about prices, uncertainty about supply and demand, uncertainty about trade and even uncertainty about political environments. Uncertainty however is not all bad. It creates certain opportunities which when exploited appropriately can create value for the company. As such it is essential that businesses realize the decision flexibilities they have and how they can put a value to the flexibility as to enable comparisons. These uncertainties create opportunities to capture future value depending on a particular view of the future trend, at a small current cost. These are commonly called Options in the financial parlance. Such options give the right (not obligation) to buy or sell an asset in the future if the conditions become favourable. Myers (1977) identified that many corporate decisions can be viewed as exercising options on real assets, and hence coined the term real options. Options to delay, abandon or expand a project are all real options in the hand of a manager.