Option Valuation of Claims on Real Assets: The Case of Offshore Petroleum Leases

TLDR

The paper develops a methodology to value claims on an offshore petroleum lease, extending financial option theory to real assets. It addresses unique theoretical and practical challenges by integrating option pricing techniques with an equilibrium model of the petroleum reserves market. The approach outperforms conventional discounted cash flow methods, yields insights for corporate strategy and government policy, and shows promising empirical results.

Abstract

This paper extends financial option theory by developing a methodology for the valuation of claims on a real asset: an offshore petroleum lease. Several theoretical and practical problems, not present in applying option pricing theory to financial assets, are addressed. Most importantly, we show the necessity of combining option pricing techniques with a model of equilibrium in the market for the underlying asset (petroleum reserves). The advantages of this approach over conventional discounted cash flow techniques are emphasized. The methodological development provides important insights for both company behavior and government policy. Promising empirical results are reported.