The Valuation of Proved Oil Reserves: Price-Induced Revision and the Random Evolution of Oil Prices
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We present two methods for valuing an oil Exploration and Production (E&P) firm, one static and one dynamic. Central to our methodology is the phenomenon of price-induced revision of bankable (a.k.a. proved) oil reserve volume. Using price-induced revision data, we may estimate the degree to which a volume of reserves changes over time; therefore we introduce market sensitivity into our valuation model: we alter the amount of production, measured in barrels, while keeping the rate of production constant, as WTI prices move higher or lower. We combine this “real options” approach with more traditional Discounted Cash Flow (DCF) valuation methods; specifically, we do not discount at the risk-free rate, but rather we use a subjective discount rate determined by the valuing agent’s assessment of non-price firm-risk. The use of a subjective discount rate reflects the reality that not all risk faced by an E&P firm is hedge-able, and therefore, unlike “textbook” real-options models, we do not arrive at a unique price for the asset being valued. The asset valuation occurs under the risk-adjusted pricing measure, Q, rather than the “real” probability measure, P, as we will be pricing future random cashflows generated from the sale of a commodity, and a commodity forward curve – which may be taken directly from the market – is composed precisely of expected future spot prices under the pricing measure, Q. Therefore, by using Q rather than P, we do not need to estimate future commodity prices – we may take our estimates directly from the observable forward curve. Moreover, our use of the pricing measure, Q, rather than P, makes the valuation of a physical asset consistent with the valuation of financial contracts that may be sold against that physical asset. Finally, we propose a model for flexible-payment debt which employs our firm valuation method. Our model is an extension of Merton (1974). We use the model to price reserve-based loans, which are a common, and important, source of capital financing for E&P firms.