Real options for risk management in petroleum development investments

Abstract

Irreversible investments made with incomplete information are the mainstay of the petroleum industry. Sequential, non-repetitive investment decisions with alternative pathways associated with exploration through full-field development are common. We demonstrate a policy development approach that combines the Bellman equation for dynamic programming with a real options valuation algorithm. This represents the first demonstration of the mathematical union of the two techniques for branching decision pathways, producing a generalized policy development framework that provides risk management of investments. Production expansion investment decisions for a Central Asian gas condensate field are analyzed using the framework. © 2006 Elsevier B.V. All rights reserved.