David G. Laughton

Reversion, Timing Options, and Long-Term Decision-Making

Discounted cash flow analysis is the most common method for evaluation of investment projects, yet practitioners worry about its shortcomings. In particular, there is concern that standard DCF comparisons may introduce bias against long-term investments. Here, we explore a possible source of such bias in the structure of the uncertainty underlying project cash flows, and the way it is incorporated into project discounting.

Real Asset Valuation: A Back-to-Basics Approach

Different valuation methods can lead to different corporate investment decisions, and the conventional “static, single discount rate” DCF approach in particular is biased against many of the kinds of decisions that corporate managers tend to view as “strategic.” Reducing the bias from valuations involves two main tasks: treating risk in a way that is consistent with observed market pricing, and accounting for the ability of companies to make decisions “dynamically” over time. The authors propose two separate tools, market‐based valuation and complete decision tree analysis, for accomplishing these two improvements in valuation. The authors also suggest working with the full distribution of future cash flows, one possible realization at a time, rather than working with the aggregate measure of expected cash flow. From a technical perspective, it is necessary to work with the full distribution to value real options properly. Valuing the cash flows one realization at a time also leads to a much better understanding of the interaction between economy‐level, systematic risks and local asset‐level, technical risks. Just as important, the proposed approaches support an effective division of labor between local asset managers, who are better positioned to model technical considerations and other asset specifics, and the central finance staff, who can ensure the consistent treatment of economy‐wide risk and to create the rules of engagement for evaluating opportunities. After presenting an overview of both the valuation and the organizational issues, the authors present a case involving a corporate investment in carbon capture and storage that illustrates both the application of the proposed methods and the various sources of bias in the typical DCF analysis.

The Potential for Use of Modern Asset Pricing Methods for Upstream Petroleum Project Evaluation: Introductory Remarks

MAP methods are continually being refined and expanded. In these concluding remarks I would like to touch on some of those developments, and then briefly to mention some steps that might be taken by an organisation that wants to explore this field further.

Complete Decision-Tree Analysis Using Simulation Methods: Illustrated With an Example of Bitumen Production in Alberta Using Steam Injection

Work has been going for several years in financial markets to deal with similar issues using methods based on subtle combinations of simulation and optimisation. Two of these combinations the Longstaff-Schwartz simulation-projection method and the stochastic programming method have been applied recently to valuations in the mining industry in situations that are analogous to those faced by the upstream petroleum industry.

Risk Discounting: The Fundamental Difference between the Real Option and Discounted Cash Flow Project Valuation Methods

The real option valuation method is often presented as an alternative to the conventional discounted cash flow (DCF) approach because it is able to recognize additional project value due to the presence of management flexibility. However, these two valuation methods can be separated on a more fundamental level by their differences in risk discounting. Real option valuation applies the risk-adjustment to the source of uncertainty in the cash flow while the DCF method adjusts for risk at the aggregate level of net cash flow. This seemingly small difference is the reason why the real option method is able to differentiate between projects according to each project’s unique risk characteristics while the conventional DCF approach cannot. This paper provides an overview of the real options and DCF valuation frameworks and discusses the differences in risk discounting that exist between the two methods. Using grade-school mathematics, this paper clearly demonstrates how, with real options, a unique project risk discount can be calculated which is directly linked to the project’s unique risk profile. It also highlights why the DCF method fails in this regard and shows why a call to “increase the Risk-Adjusted Discount Rate” is an incomplete solution at best. Finally, a heap-leach project and satellite reserve development project are valued with both techniques and the difference in investment conclusions is explained in terms of the risk-discounting concepts discussed here.

Valuing a Multi-Zone Mine as a Real Asset Portfolio - A Modern Asset Pricing (Real Options) Approach

Modern asset pricing (MAP; commonly known as real options valuation) has been used as an alternative to discounted cash flow (DCF) methods in the mining industry to improve the representation of project structure within project valuation models. Previous mining applications of MAP have tended to treat the ore deposit as a homogenous entity as opposed to a heterogenous one in which the deposit can be subdivided into zones differentiated by size, quality and location. This is an inadequate approach for some mining applications because management may implement operating strategies that capitalize on geological structure such as selective zone closure in response to low mineral prices. This paper introduces a project structure model that reflects the heterogenous nature of mineral deposits by representing the project as a real asset portfolio in which each zone represents a portfolio asset. The project is operated in discrete intervals by choosing, at the start of each interval, an operating mode from a set of competing operating modes. Each mode specifies the combinations of zones that will be active and the amount of project capacity that is built, abandoned or temporarily closed. A two-zone mining example is used to demonstrate the proposed model and show how operating strategies that capitalize on geological structure can add value.