Abstract: The Value of Uncertainty: An Explorationist Looks at Option Analysis

Michael David Cochran

Option analysis is a method to value the opportunity to invest in a project with uncertain value; one has the right but is not required to invest. The decision is, therefore, contingent on new information.

Methods to value such options which were originally developed to value stock options; they have been extended to valuing resource projects. One will make a decision to invest contingent upon new information; the decision is dependent on learning about the value of the project.

The option value is an increasing function of uncertainty and time to exercise, and a decreasing function of the convenience yield of the resource. There is a project value or hurdle which triggers the investment; this value behaves similarly to the option value--increasing with uncertainty and time and decreasing with convenience yield.

The exploration/development process is a sequence of contingent decisions based on new information as to the value of the project. The main causes of uncertainty are reserves, prices, chance of success, and cost. The option value is large when these uncertainties are large. The higher the potential to learn, the more value the option has. As we decrease uncertainty, we decrease trigger or hurdle value which causes us to exercise the option or invest.

There are certain projects for which the expected value is negative that have projects for which the expected value is positive that should not be exercised yet; less uncertainty is required (bad news could occur).

The results of option analysis profoundly affect exploration/development strategy. Under an option strategy one builds a large inventory of options, expends money and/or time to reduce the uncertainty and invests in the few that satisfy the exercise hurdle. This requires discipline to focus on expending monies to decrease the uncertainty, to drop options for which the hurdle is not expected to be reached, and to exercise only those options for which the uncertainty has been sufficiently decreased so that the hurdle value can be reached.

AAPG Search and Discovery Article #90951©1996 AAPG International Conference and Exhibition, Caracas, Venezuela