Integration of financial and strategic planning using a real options framework bolsters capital spending decisions

Strategic planning and real options theory begin with the end in mind. Both require the decision-maker to think forward through all possible and probable scenarios and options and reason backward. These approaches force an oil and gas company planning capital investments to take a long-term, strategic look into the future in order to accomplish certain objectives.

Real options theory shows that public policy that reduces uncertainty encourages investment, as it helped the California State Lands Commission develop an optimum royalty rate schedule. Also, real options theory helps operators determine the best way of proceeding with a project based on the price of oil or gas and the volatility therein.

In most organizations financial planning and strategic planning are provided independently using completely different analysis tools and people. A relatively new branch of financial engineering, real options theory provides a quantitative framework that integrates the two business disciplines. This combination enables decision-makers to view the future as a portfolio of strategic options-the option to wait, slow down, expand, abandon, stop, start up, etc.

Acquisitions can be evaluated quantitatively as growth options with a focus on additional flexibility and potential opportunities. The piecemeal approach of having different groups working on financial and strategic issues independently prevents a business from truly understanding all the different ways value can be created at various price triggers or under various circumstances. Additionally, real options theory is robust enough to evaluate competitive situations by incorporating game theory principles.

Real options theory adds value over the traditional discounted cash flow (DCF) method of analysis by addressing the:
Value of waiting and learning before investing.

Additional value of strategic investments, such as research and development, where additional options are created by investments.

Value of operating options such as slowing down, expanding, abandoning, stopping, and starting up the operation after being shut in.

Value of switching; for example, using gas instead of oil to fuel a power plant.

Fact that project risk typically is not constant throughout the life of a project, especially when accounting for project options.

Real options and DCF valuations generally differ when investments are just above the break-even point. When investments are significantly above the break-even point, DCF and real option values are typically the same. When the net present value (NPV) is high, most options that provide additional flexibility, or real option value, will not be exercised or have much value. Real options analysis shows why, in a variety of industries, the hurdle rate is often two to three times a company's weighted average cost of capital (WACC).

This spread, or insurance cushion, between a company's cost of capital and its hurdle rate is simply the value of flexibility that is not accounted for in the traditional capital budgeting analysis. When the underlying asset is volatile, such as is the case with oil prices, most investors require a premium over the zero-NPV hurdle because future project economics are highly uncertain.

In both real options and DCF analysis, the investment objectives are to maximize the rate of return while minimizing risk, or in other words, to maximize the investor's utility. It is still the risks that drive the returns; arbitrage opportunities, or "free lunches," are rare.

The biggest difference is that real options analysis incorporates the opportunity cost for waiting, expanding, etc. Real options can be thought of as potential opportunities that become economically viable at various price triggers. If the potential opportunity (real option value) is greater than the DCF value, then in order to maximize value, the investor should be guided by the option; that is, if the value of waiting is greater than the DCF value of investing now, then the investor should wait.

Compared with earlier prediction models, real options theory better predicts that investments are not nearly as sensitive to changes in interest rates and tax policy as they are to volatility and uncertainty. There was a big difference in how much the US Federal Reserve Board's interest rate reductions affected the financial markets last year vs. the effect of the Sept. 11, 2001, terrorist attacks on the US. As uncertainty increases, investors typically wait and see before investing.

People apply real options principles daily with no formal real options training. When someone thinks he may lose his job, he naturally is less willing to spend money on unnecessary items. Future uncertainty typically causes people to wait and learn before getting married or having children. In real life, projects are not executed as soon as the NPV is greater than zero.

Oil companies typically conduct pilot studies and may conduct seismic surveys and thereby exercise the option to wait and learn before doing full field development. Production facilities are not shut in as soon as they start losing money, because of the uncertainty of price and the costs of shutting down and restarting the operation.

DCF, which was initially developed to value bonds, is a narrowly focused type of analysis that does not consider the many options a manager faces when unexpected events such as low oil prices are encountered. During a period low oil prices, an oil field can be partially or fully shut in, depending on the various priced-based economic trigger points. Conversely, during a period of high oil prices, a field can be expanded or leveraged for more acquisitions.

Real options analysis provides for active but not overactive management. Inherent within the analysis is the managerial flexibility to depart from initial plans when circumstances change. It provides additional value over a passive "hold and hope" management style. To stay competitive, especially in a volatile business environment, it is critical that managers have the flexibility to revise initial business plans. Volatile businesses derive the most value by having the flexibility to exercise a diverse portfolio of real options.

Real options and uncertainty

As uncertainty or volatility increases, the real option value to wait and learn increasesm whereas DCF value is reduced because of an increased discount rate or WACC. In real options analysis there are asymmetric payoff values, i.e., the downside risk is separated from the upside potential. The reason the payoffs are asymmetric is because a risk-averse investor is not going to exercise an investment, other than possibly for strategic reasons, when prices are below the break-even point.

As uncertainty is increased, the option or potential value also increases. Also, as volatility increases so does the value of the options; that is, at low prices the options to wait, slow down, shut in, and abandon become more valuable.

Conversely, at high prices the option to expand becomes attractive. Therefore, higher volatility leads to more potential option value. Times of turmoil and increased uncertainty increase opportunity, or real options, value. Options that were not economic before may become economic because increased uncertainty changes the way people spend money, as during the late 1970s oil crisis when people purchased economy cars, thereby turning gas guzzlers into stranded costs for the auto industry. It is important to note that these options are only valuable if management has the flexibility to exercise them in a timely manner.

Option to wait, learn before investing

In negotiations, typically the party with the most patience gets the best deal. Most successes involve the need for patience, and most failures are caused by a lack of it. As in hunting or fishing, investors learn the importance of using patient persistence so they are ready when opportunity knocks. Waiting to pull the trigger takes a certain level of discipline and an understanding of why at times waiting adds value.

Deciding to invest in projects that are highly profitable is easy, but when uncertainty is high and profit margins are thin, there are times when it is best to wait and learn.

This article is not advocating procrastination but rather optimally exercising the best available options at the best time using a real options framework.

Real options theory provides the framework for evaluating the timing of making irreversible investment decisions when uncertainty is present. Not considered in this article are situations of investment competition in which there are strategic reasons for waiting, such as if a competitor has the opportunity to make a preemptive investment and erode the investor's market share.

When an irreversible investment is exercised, the option to wait and get more information is no longer available. By exercising the option, the investor gives up the opportunity to wait and learn, or to see if the price is going to fall or conditions will significantly change.

As uncertainty increases, with everything else being the same, the value of the option to wait and learn increases. Traditional DCF analysis tells the analyst to invest in all projects that have an NPV greater than zero.

Real options theory, however, considers the opportunity cost of waiting for a better time in the future to make the investment.

Also, traditional NPV analysis tells the investor not to invest when the NPV is equal to or less than zero. Conversely, real options acknowledges the fact that a project that currently has a negative NPV could be potentially valuable in the future if the price of the underlying asset, such as oil, is volatile enough and the operator has the option to wait for a higher price before proceeding.

Real options analysis is strategic in that it begins at the end and is solved backwards, like decision tree analysis (DTA). DTA assumes a constant discount rate, whereas the real options approach utilizes a risk-neutral approach that properly accounts for project risk. When the best option is to wait there is no risk. This approach is best thought about as a supplement to standard DCF analysis and DTA.

The figure illustrates a simple example of this concept. Assume an oil price of $15/bbl and a break-even price of $14.50/bbl. Assume the oil price can increase or decrease 30%/year. In Case 1, let's say an investor takes on the project initially at $15/bbl. In Year Two, the price will be either $19.50/bbl or $11.50/bbl.

Notice that if the price went to $11.50/bbl, the project is no longer economic. In Case 2, the investor waits to see the Year Two price-getting more information. If the price drops to $11.50/bbl, he doesn't invest. If the price increases to $19.50/bbl, he does invest. The important concept to note here is that by investing at $15/bbl he forgoes the option of waiting and investing at a better time. This relatively new way of evaluating investments can add significant value and is presently not incorporated into the DCF way of thinking. Real options theory provides management the flexibility to wait until the situation is good or not to invest at all when conditions worsen.

Investments that create strategic or growth options

Strategic investments are investments that lead to further options. An example of this is exploration drilling or the development of a new drug by a pharmaceutical company. On average it costs $360 million and takes a decade to bring a new drug to market. Only one explored chemical in 10,000 becomes a prescription drug, and once a drug reaches the market, it has a 70% chance of failing to earn the cost of invested capital.¹ These initial investments can be thought of as entry fees that could provide further future options.

NPV undervalues projects that occur in stages, whereas options are created from initial investments. Combining the NPVs provides the wrong answer. The reason is that the second stage is an option that may or may not be exercised. If the option is not exercised, there is no risk. Therefore, the traditional constant discount rate applied uniformly across the cash flow stream is incorrect.

Option to switch mode of operation

Real options theory provides a framework for optimizing the mode of operation. A power plant that can use either oil or gas has a strategic advantage over one that can use only one source of fuel. People switch jobs, careers, schools, etc., to try to incrementally improve their current situation.

During times of low oil prices-when the NPV of the expected loss (assuming a cash flow forecast) exceeds the tangible and intangible NPV cost of shutting down-the option to shut down becomes valuable. An operation that cannot be shut in is less valuable. When price uncertainty and shutdown and restart costs are high, an operation will optimally operate losing money until the economics of shutting down become favorable.

Before an operation is shut down, most operators will reduce their fixed costs, such as administrative costs, as much as possible. Conversely, when the operation is already shut in, the option to restart becomes valuable when the NPV of operating (assuming an oil price and recoverable oil and gas reserves forecast) exceeds the NPV of restarting. Notice that if the start-up and shutdown costs are zero and there is no price uncertainty, the operation would be optimally shut in when marginal profits are less than or equal to zero.

The option to abandon an operation becomes valuable when the NPV of future losses (assuming an oil price forecast) exceeds the cost of abandonment plus any salvage value or the value of its best alternative use. It is important to note that if the abandonment liability is large enough, an operator will stay in a money-losing operation in order to delay abandonment and any possible cleanup costs.

Maximizing royalty revenue

Real options theory shows that public policy that reduces uncertainty will encourage investment, and vice-versa.