Dealing With Uncertainty in Petroleum Exploration:

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2001 Energy Finance Conference Austin, Texas
Dealing With Uncertainty in Petroleum
Exploration Anadarkos Use of Real Options

Ron Bain and Steve Rutherford Technology and
Exploration Planning Group Anadarko Petroleum
Corporation
February 22 - 23, 2001
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Industry Status of Real Options

• Recognized Leaders in Real Options
• Anadarko
• Shell
• Enron
• Mainly Strategic Uses Implemented at Corporate
  Level
• High Level of Interest Throughout the Industry

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Status of Real Options in Anadarko

• Primarily Strategic Applications Implemented at
  Corporate Level
• Deep Water Lease Sale Valuations
• Farmout Opportunities
• Play Entry Options
• Starting to be Implemented at Division Level
• Stochastic NPV Evaluations are Beginning to
  Include Optionality

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Timeline

• 1995 - Began Internal Research on Applications of
  Real Options to EP Project Valuations
• Formal recognition of significant value of
  inherent optionality (intuitive to quantitative)
• Literature searches
• Attacked simple problems with Black-Scholes eqn.
• Valuing international PSAs Lease sale bid
  valuations
• 1996 - Realized We Were Sorely Lacking in Tools
  to Solve Real World Problems
• Changed focus to Active Learning types of
  problems
• Consulted with Analysis Group Economics (Martha
  Amram)
• Developed methodologies for valuing active
  learning
• Developed Two-Learn prototype software

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Timeline

• 1997 to 1998 - Digestion Period
• Implemented qualitative Real Options company wide
• Management (some) developed a Real Options mind
  set
• No consultants or software developments during
  this period
• 1999 - Renewed Focus on Tool Development
• Retained Larry Chorn of ROCE, Inc. to advise on
  Real Options implementations
• Focused on more complex, real world problems
• Employed Rainbow Options value deep water lease
  sale prospects incorporating
• Technology development option
• Explore/abandon option
• Delineate/develop option
• Proprietary software development

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Timeline

• 2000 - Increasing Commitment to Real Options
• Continuing consultancy with ROCE (Real Options
  course)
• Increased Real Options staff in Exploration
  Planning Group
• Increased Real Options valuations in operating
  groups
• Exploring liaisons with companies to facilitate
  tool development
• Underwriting development of FlexAble
• Networking the Real Options community

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Issues Within Anadarko

• Lack of General Set of Tools
• Impacts ability to solve useful problems
• Impacts ability to disseminate of Real Options
  technology
• Corporate Understanding of Real Options
• How do we explain this stuff to management and
  staff?
• Strategic vs. tactical applications - helicopter
  philosophy
• Buy-In/Credibility
• Where are the corporate experts housed? TURF
• Do people really believe the results? Corporate
  patience
• Very important to present examples where Real
  Options valuation says dont do this project -
  neutralize the bias!

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Issues Popular Misconception 1

• ROA uses a risk-free discount rate for everything
  - This cant be right!
• In ROA income and expense cash flows are always
  discounted using the companys specified hurdle
  rate
• By analogy to financial options, strike price, X,
  is often discounted using the risk-free rate, but
  only during the option period, t
• r is also the drift rate and impacts the asset
  value volatility model

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Discount Rates in Financial Options

• The use of the risk-free rate arises from the
  concept of a risk-free portfolio
• The value of a financial option is established
  within the context of a risk-free portfolio
• Assumption - Equities market is efficient and
  frictionless
• Requirement - Risk free portfolio must be free of
  arbitrage risk
• Result - Use of risk-free interest rate is
  mandatory

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Discount Rates in Real Options

• Through analogy to financial options many
  practitioners often use the risk-free rate
• Natural to compare stock returns to a risk free
  interest rate
• Real markets are different
• Neither efficient nor frictionless
• Arbitrage risk is generally not a factor
• Funds invested in OG projects must earn the
  corporate hurdle rate
• Funds not invested in a project are not generally
  banked. They are diverted to other projects
  earning WACC
• Bottom Line - Anadarkos Philosophy is to use r
  corporate hurdle rate/WACC in Real Options
  valuations

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Issues Popular Misconception 2

• ROA is just a way to make dog projects appear to
  be valuable
• ROA identifies and values upside potential in a
  project
• Whether the option is a good deal or not depends
  on the cost of the option relative to the value
  of the option
• In financial options cost of option is by
  definition value of the option. NOT SO IN REAL
  OPTIONS!
• Paying more than the option is worth destroys
  project value
• Paying less ensures meeting hurtle rate
  requirements
• Sows ears will not be turned into silk purses by
  ROA