Switching from oil to gas production in a depleting field

Author's accepted version (post-print).Available from 26/05/2020.We derive an optimal decision rule with regards to making an irreversible switch from oil to gas production. The approach can be used by petroleum field operators to maximize the value creation from a petroleum field with diminishing oil production and remaining gas reserves. Assuming that both the oil and gas prices follow a geometric Brownian motion we derive an analytical solution for the exercise threshold. We also propose an explicit solution for the option value that is new to the literature. Numerical examples are used to demonstrate the threshold and option value for a generic petroleum field. Both the threshold and option value solutions are relevant for application to other real options cases with similar features (e.g. other types of switching options or a perpetual spread option).acceptedVersio

Capacity optimization of an innovating firm

publishedVersio

Green Investment under Policy Uncertainty and Bayesian Learning

Many countries have introduced support schemes to accelerate investments in renewable energy (RE). Experience shows that, over time, retraction or revision of support schemes become more likely. Investors in RE are greatly affected by the risk of such subsidy changes. This paper examines how investment behavior is affected by updating a subjective belief on the timing of a subsidy revision, incorporating Bayesian learning into a real options modeling approach. We analyze a scenario where a retroactive downward adjustment of fixed feed-in tariffs (FIT) is expected through a regime switching model. We find that investors are less likely to invest when the arrival rate of a policy change increases. Further, investors prefer a lower FIT with a long expected lifespan. We also consider an extension where, after retraction, electricity is sold in a free market. We find that if policy uncertainty is high, an increase in the FIT will be less effective at accelerating investment. However, if policy risk is low, FIT schemes can significantly accelerate investment, even in highly volatile markets

Stepwise Investment and Capacity Sizing under Uncertainty

The relationship between uncertainty and managerial flexibility is particularly crucial in addressing capital projects. We consider a firm that can invest in a project in either a single (lumpy investment) or multiple stages (stepwise investment) under price uncertainty and has discretion over not only the time of investment but also the size of the project. We confirm that, if the capacity of a project is fixed, then lumpy investment becomes more valuable than a stepwise investment strategy under high price uncertainty. By contrast, if a firm has discretion over capacity, then we show that the stepwise investment strategy always dominates that of lumpy investment. In addition, we show that the total amount of installed capacity under a stepwise investment strategy is always greater than that under lumpy investment

Valuing quantity flexibility under supply chain disintermediation risk

We consider a supply chain with one supplier and one retailer in which the parties develop a quantity flexibility contract to specify the conditions of procurement activities. The contract allows the retailer to adjust the initial order quantity after the partial or full resolution of demand uncertainty, which helps the retailer reduce supply-demand mismatches. We use the multiplicative martingale model of forecast evolution to analyze the impact of lead-time reduction on the value of quantity flexibility for the retailer. We find that the shorter the lead time, the higher the value of quantity flexibility. Quantity flexibility may, however, also cause supply chain disintermediation problems for the retailer, such as the supplier bypassing the retailer and selling its products directly to end customers. We incorporate the "contracts as reference points" theory into our quantity flexibility contract model to capture the impact of supply chain disintermediation on the retailer's profit. This approach allows us to analyze the trade-off between decreasing supply-demand mismatches and increasing supply chain disintermediation problems. We show that the impact of lead-time reduction on decreasing the disintermediation risk highly depends on the critical fractile. We also find that the supplier's cost structure has a significant effect on the trade-off. When the supplier's initial investment cost is relatively low, the disintermediation problems become less important. (C) 2016 Elsevier B.V. All rights reserved

Green capacity investment under subsidy withdrawal risk

Subsidies initially installed to stimulate green capacity investments tend to be withdrawn after some time. This paper analyzes the effect on investment of this phenomenon in a dynamic framework with demand uncertainty. We find that increasing the probability of subsidy withdrawal incentivizes the firm to accelerate investment at the expense of a smaller investment size. A similar effect is found when subsidy size as such is increased. When subsidy withdrawal risk is zero or very limited, installing a subsidy could increase welfare. In general we get that the larger the subsidy withdrawal probability, the smaller the welfare maximizing subsidy rate is. Therefore, a policy maker aiming to maximize welfare should try to reduce subsidy withdrawal risk

Transmission Investment under Uncertainty: Reconciling Private and Public Incentives

Private companies (PCs) in restructured electricity industries determine facility investment timing and sizing. Such decisions maximize the PC’s expected profit (rather than social welfare) under uncertainty. By anticipating the PC’s incentives, a welfare-maximizing transmission system operator (TSO) shapes the network to align public and private objectives. Via an option-based approach, we first quantify welfare losses from the PC’s and TSO’s conflicting objectives. We show that by anticipating the optimal timing and capacity decisions of the profit-maximizing PC, the TSO is able to reduce, though not eliminate, welfare loss. Next, we exploit the dependence of the PC’s capacity on the TSO’s infrastructure design to devise a proactive transmission-investment strategy. Hence, we mitigate welfare losses arising from misaligned incentives even in relatively uncertain markets.Peer reviewe

Real options approach for a staged field development with optional wells

With the decreasing average size of new discoveries in mature production areas, the uncertainties in the base of oil field investment decisions are continually increasing. Fewer appraisal wells, which allow to decrease the amount of subsurface uncertainty, are typically drilled before the development of a small field compared to large fields. In this context, novel solutions must be established to commercialize small discoveries under technical and market uncertainties. In such conditions, managerial flexibilities, which enable to change the course of the project in the event of new information acquisition, must be critically considered in the investment valuation process. Combining the real options approach and decision analysis, we establish a novel model to identify the additional value created by a sequential drilling strategy for field development under oil price and resource uncertainty. In particular, we capture the sequence of the key investment and operating decisions pertaining to a marginal field development in cooperation with an oil industry partner, which corresponds to a synthetic yet realistic project case. By considering the flexibility in dividing the production well drilling into two stages, we adopt the least-squares Monte Carlo algorithm to evaluate the option to wait to expand the production by drilling additional wells. Furthermore, we identify the conditions in which the staged (phased) development is preferable against standard development. We propose a decision rule to determine the optimal expansion timing based on the acquisition of new information on the reservoir and oil price uncertainty. Our results suggest that staged development carries large upside potential for the marginal field development under extensive reservoir uncertainty. In addition, partial hedging against the downside risks in the staged development can enhance the project's economy in a sufficiently significant manner to justify investment

Volume flexibility and capacity investment under demand uncertainty

The paper considers optimal capacity investment decisions under uncertainty taking a real options approach. Concerning the production decision, we study a flexible and an inflexible scenario. The flexible firm can costlessly adjust production over time with the capacity level as the upper bound, while the inflexible firm fixes production at capacity level from the moment of investment onwards. We find that the flexible firm invests in higher capacity than the inflexible firm, where the capacity difference increases with uncertainty. For the flexible firm the initial capacity utilization rate can be quite low, especially when investment costs are concave and the economic environment is uncertain. As to the timing of the investment there are two contrary effects. First, the flexible firm has an incentive to invest earlier, because flexibility raises the project value. Second, the flexible firm has an incentive to invest later, because costs are larger due to the higher capacity level. The latter effect dominates in highly uncertain economic environments. Our model being dynamic enables us to derive the at first sight counterintuitive result that an increase in capacity holding cost raises the capacity level the firm invests in