Monte Carlo evaluation model of an undeveloped oil field

Abstract

In this article we develop and implement a model to value an undeveloped oil field and to determine the optimal timing of investment. We assume a two factor model for the stochastic behavior of oil prices for which a closed form solution for futures prices can be obtained. The advantage of this model is that is allows for the term structure of futures prices to be upward sloping (contango), downward sloping (backwardation) and also humped. We use Monte Carlo simulation methods for solving the problem. Since the decision to develop the oil field can be taken at any time until the expiration of the concession, the option to invest is of the American type. This type of options are solved by the numerical solution of the appropriate partial differential equation. If we assume, however, that the decision to invest (exercise the option) can be made at a finite number of points in time instead of continuously, the problem can be solved using simulation methods. Apart from being more intuitive, Monte Carlo simulation methods easily allow for the consideration of many additional random variables such as costs, amount of reserves, etc.