Modern Asset Pricing and Project Evaluation in the Energy Industry
The paper is available in .pdf - here.
It was published as
Western Centre for Economic Research Information Bulletin 56 (2000).
It is a corrected and expanded verison of a review commissioned by
Journal of Energy Literature 6-1(2000) 3-46.
Note: The term modern asset pricing has been replaced since 2003 by market-based valuation. The two terms mean the same thing.
Abstract
A key task of any commercial organisation is the choice of its asset configuration. This choice cannot be made without the generation and evaluation of alternatives. Asset valuation is usually a key aspect of the evaluation process.
For several decades in the energy industry, the most common form of asset valuation for these purposes has been a style of Discounted Cash-Flow (DCF) analysis, which, in this paper, we call the Standard DCF approach. However, over the past five years in particular, an increasing number of organisations in the upstream petroleum and electrical generation industries, among others, have been experimenting with the use of another approach. The most common term now for this is Real Option Valuation (ROV), although, for reasons that are made clear in Section 1.5, we prefer the more general term: Modern Asset Pricing (MAP).
At this point, the future role of MAP is not clear, and there is much fundamental work that remains to be done in developing MAP technology. However, there is enough activity and interest in the use of MAP methods, particularly in the energy industry, that it is appropriate to undertake a selective review of what is known publicly, and what remains to be done, on this topic.
This review builds on a special issue of The Energy Journal on the topic of The Potential for Use of Modern Asset Pricing Methods for Upstream Petroleum Project Evaluation, guest edited by one of us.
In Section 1, we address the following questions, with reference, where needed, to The Energy Journal issue.
- What is wrong with Standard DCF? (It is costly to introduce new valuation techniques, so there has to be a reason for doing so.)
- How does MAP overcome some of the deficiencies of Standard DCF?
- What ideas are behind the MAP approach to asset valuation?
- How are MAP analyses done?
- Why we are reviewing MAP rather than restricting our attention to Real Option Valuation (ROV), which is the focus of almost all of the attention and writing in this area?
We then list some issues that need to be addressed about the use of MAP in the energy industry.
The rest of the paper is a review of publicly reported progress in addressing the issues raised in the Introduction. Our intent is to provide some assistance to a group of readers, who have made some initial attempts to use MAP methods, and who want to know more about the technical aspects of implementing MAP analyses as they proceed to the next step in doing so. If the reader is a novice with MAP or ROV, we would suggest that he or she refer to the appropriate parts of The Energy Journal (Laughton 1998a) as needed. More experienced ROV analysts may find this review useful as well, but more selectively, and possibly because we present a view of ROV that is not exactly the same as their own.
To keep the paper manageable, we focus on the upstream petroleum industry, with only a few references to electricity generation. Furthermore, we discuss the valuation of production assets exclusively, although similar issues arise in the valuation and management of long-term sales agreements.
Sections 2 and 3 examine two modelling issues that arise in MAP analyses:
- the construction of the scenario tree and the policy set to be used in the analysis; and
- the determination of state prices for states on the scenario tree.
Section 4 deals with computational issues. Section 5 describes some publicly reported applications. Section 6 mentions two empirical studies. Section 7 concludes.
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