An Analysis and Comparison of Different Real Option Approaches

Yanhua Yao¹, John Van der Hoek¹, and Peter Behrenbruch^2
1 The University of Adelaide, Adelaide, Australia
² Australian School of Petroleum, Adelaide, Australia

It's obvious that many oil companies struggle with decisions about high risk petroleum investments. It's hard for petroleum people to make a decision when many variables are uncertain. And also it is harder for petroleum people find an opportunity worth when they apply traditional project valuation tools.

Real Option Valuation is a valuation tool for evaluating opportunity value and managing strategic investments in an uncertain environment. Based on academic research in finance and business management, Real Option Approach extends option-pricing tools from finance sector to real underlying management. Despite the Real Option thinking has been widely accepted in risk management, Real Option Approach is in “hot” debate. An implicit definition of “Real Options” causes to the consistence between Real Option approaches. Real Option is termed as the company has a right not an obligation to invest in future. It is ambiguous that if the future opportunity belongs to a technical opportunity or a market opportunity. Thus, there come up numeral Real Option approaches.

We elaborate five Real Option approaches, which are the Classic Approach, the Lenhrman Approach, Market Disclaimer Approach (MAD), the Smith Approach, as well as the Luenberger Approach. Meanwhile, we compare them by modelling main two types of flexibilities: technical flexibility and market flexibility. By contrasting these approaches, one can see the functions of modelling uncertainty in five Real Options approaches.