Real options valuation for refinery and petrochemical investments: A feasibility study in Indonesia

Abstract

Petroleum products serve as a main driver in economic development of Indonesia through their uses as energy source and raw materials for petrochemical industries. Indonesia still relies on imported petroleum products as fuel and raw materials for petrochemical industries, where 35 % of fuel demand is and 50 % of petrochemical industries raw materials are fulfilled through imports. This situation drives the urgency to a new investment to develop integrated oil refinery and petrochemical complex to fill the market demand and close the gap of imported products. As the risks of investing in a refinery or petrochemical plant are massively high, project sponsors need comprehensive information on project feasibility. This research will examine how does Real Options Valuation is compared to Discounted Cash Flow method in providing the feasibility information of the project and how incorporating ROV to assess the feasibility of the project improve investment decision of the project sponsors. This research will be the first to studies the impact of delay of timing in investment decision and utilize ROV as an investment decision-making tool for an integrated refinery and petrochemical project in Indonesia. Two cases were studied in this research, which is Base case scenario where the project is executed in sequence starting with design phase and immediately followed by construction phase, and Alternative case scenario where additional 2 years between design phase and construction phase is added for further market analysis. Managerial flexibility was assessed in the ROV using abandon option after design phase. The DCF analysis result shows that both cases are economically feasible with positive NPV of US$ 1085 million and US$ 812 million for respective cases and IRR of 11.87 % and 11.78 % which is above target IRR of 11 %. Further analysis using ROV shows that the managerial flexibility feature in ROV resulted in additional option value of US$ 1546 million and US$ 795 million on top of the NPV for respective cases. It is concluded that Base case would be favorable just by taking into account the static assumption used in the evaluation. However, considering the uncertainty and risk of the market situation, it is worth taking additional period to validate market situation proposed in Alternative case. On the feasibility assessment method, it can be concluded that while DCF relies on fixed input of cash flow projection assumed during project evaluation and does not have the flexibility to cope with uncertainty in the future, ROV can capture the risk of uncertainty in the future and give the flexibility to project sponsors to exercise available options. Considering the risk from future uncertainty in the long term and the irreversibility nature of refinery and petrochemical investment, utilizing ROV to assess the project was proven effective and beneficial in providing more comprehensive investment recommendations to project sponsors.