A CASE STUDY OF APPLYING LEAST SQUARES MONTE CARLO METHOD
I. INTRODUCTION
Indonesia has many potential undeveloped reserves and currently still depends on petroleum resources to support its economy. The uniqueness of this industry with a high uncertain in oil price and subsurface factors cause the investment decision in this industry should be made carefully.
Currently, many practitioners still use net present value (NPV) resulted from discounted cash flow (DCF) method as a guidance for their investment decision making. However, this method was failed to react on new information. On this methodology, it assumes that once of investment is made, the project will run its course without intervention. It’s contrary to the fact that the decision maker has a flexibility to intervene that project if there is new information in the future.
Real Options (RO) is an alternative method for project valuation that can accommodate flexibility management in adapting and revising future decisions in response to changing circumstances. The need for the RO approach in valuing petroleum assets is essential for stimulating growth of petroleum resource development in Indonesia.
From the available methodologies in Real Options, Least Squares Monte Carlo (LSM) originally proposed by Longstaff and Schwartz in 2001 has an ability to handle the complexity of real petroleum projects.
The advantages of this method are that it is simple, requires less computational time, and can be applied to value complex options with many underlying stochastic variables.
The objective of this paper is to extend this method to value the petroleum Assets in Indonesian PSC regime. In this study, we examine the applicability of the LSM method in valuing one PSC block having operating flexibility options. Then, we compare the LSM and DCF valuation results with the actual results.
II. EXTENDED LSM METHOD TO VALUE PETROLEUM PROJECT IN INDONESIA
The key point of LSM is that it can efficiently identify the conditional expected holding value of contingent claims at times before expiration by a simple regression from the maturity day backward to the starting time. Once the holding values at each time spot of the different paths are identified, we can compare the values of early exercise and holding value at any time on each path, and optimal early exercise strategy can thus be made.
The objective of the LSM is to provide a path wise approximation to the optimal stopping rule that maximizes the contingent claim’s value.
In this study, we investigate the possibility of extending the LSM method to value petroleum assets in Indonesian PSC regime. We will assume that a manager can choose among oil field status. For example, when considering the option to abandon alone, there will be two management options available to:
1. Continue production, or
2. Abandon the project at that time
General Algorithm Framework of LSM Method is as follows (Longstaff and Schwartz, 2001):
• Discrete time into L exercising points
• Simulate N paths of the underlying(s) dynamics under risk-neutral measure
• Determine optimal exercising time of each path
• Backward in time
• Compare immediate payoff and continuation value (estimated by least squares)
• Discount payoffs of all paths to time t
• Average all payoffs to obtain the risk-neutral price
A Matlab-based program is developed for valuing PSC block using the LSM method.
III. RESULT
In this case study, the accuracy of the LSM method will be tested to one PSC block that was acquired in 2001. This would be compared with the original valuation result generated by DCF method.
In this study, the abandonment action was assumed no cost by the scenario if we abandon the project we can relinquish this block to government.
The result of the LSM and DCF method compare with actual cash flow generated summarized in below
(in $ million)
Block X DCF Fcst LSM Fcst PV Actual CF
@15% 2001 – 2005 @ 15%
Field A 15.9 24.17
Field B 7.2 39.33
Field C 9.8 44.73
Total 32.9 108.23 45.5
Table 1. RO and DCF Forecast vs Actual Cash Flow
Currently these fields are still on production. With the current high oil price, we can expect more value from these blocks than DCF value.
Table 1 above summarized the value generating from both option and original DCF pricing on each field based on an evaluation date of 2001 year end. RO method is more likely to reveal a true picture of the value of these fields than DCF method.
The results reported in this paper are preliminary, pending a careful statistical examination of the robustness of the valuation procedure. However, in that sense, this paper concludes that LSM can be applied to the PSC regime to value petroleum resources in Indonesia. ROV is more likely to reveal a true picture of the worth of petroleum assets in Indonesia than any other currently available technique. As such, it has the potential to form a proper basis for investment decision making, as a result of which production of the undeveloped reserves in Indonesia can be stimulated.