The Value of Purchasing Information to Reduce Risk in Capital Investment Projects
Authors: Chorn L.G. , Carr P.P. 
Published: December 2007

Successful investment management of capital-intensive, long-lived energy projects requires an understanding of the economic uncertainties, or risks, as well as the mechanisms to resolve them. Industry traditionally manages these risks by purchasing information (seismic, well testing, appraisal drilling, reservoir simulation, market capacity and price studies, etc.) about the project and making incremental investments as new information reduces the uncertainties to acceptable levels.

Traditional discounted cash flow analyses cannot readily deal with valuing information. We suggest that the purchase of information about a project has considerable value and can be treated as purchasing an option on the project. As with options on equities, if the information leads to the expectation of a positive investment outcome, the project should be funded. Similarly, options on capital investment projects also have a time factor dictating value and the proper time to undertake the investment.

This article discusses the application of option pricing techniques (OPT) to valuing information. We show how OPT is used to value the information surrounding a production capacity decision for an offshore gas field development. In the example, we value the field development alternatives and the acquisition of incremental information for the alternative selection process. As a further extension of OPT to capital investment projects, we create a dynamic model to identify investment alternatives to capture additional value over the project's lifetime. The dynamic model uses information acquired in development drilling and field operations to maximize the investment outcome.

Introduction

In the last decade, the energy industry has added value creation to its traditional set of performance metrics, i.e., reserve replacement and production volume. Within the same period, the industry's universe of investment opportunities has rapidly grown. However, the trend for many attractive opportunities is towards increasingly complex field and infrastructure developments requiring the expenditure of billions of capital dollars over the project's life; containing extensive uncertainties in timing, technical and financial dimensions; depending on synergies between upstream and downstream activities; and resulting in large positive cash flows distributed over twenty or more years. These uncertainties and project complexities make project financial analysis much more demanding. In particular, the financial analysis must properly reflect the opportunity to create value in a project by resolving the uncertainties and define an investment approach to maximizing the project value.

Traditional financial tools, such as discounted cash flow (DCF), may undervalue the upside associated with these long-lived and uncertain projects relative to what management intuitively senses they are worth. DCF is unable to value management's insight regarding changing technologies, market conditions, and the impact of leveraging. Often these types of projects are defmed as strategic and accepted for inclusion into the company portfolio in spite of an unfavorable or marginal valuation.

Why does DCF fail to consider upside value? We believe that traditional approaches do not adequately value the flexibility in investment behavior created by management's use and acquisition of new information. New information about a project allows management to adjust project scope, investment rate, production rates, etc., to accommodate uncertainties related to price, market, cost, as well as reserve size.

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