SPE-174868-MS

A Real Options Approach to the Gas Blowdown Decision

Philip Thomas, and Reidar B. Bratvold, University of Stavanger

Copyright 2015, Society of Petroleum Engineers

This paper was prepared for presentation at the SPE Annual Technical Conference and Exhibition held in Houston, Texas, USA, 28 –30 September 2015.

This paper was selected for presentation by an SPE program committee following review of information contained in an abstract submitted by the author(s). Contents
of the paper have not been reviewed by the Society of Petroleum Engineers and are subject to correction by the author(s). The material does not necessarily reflect
any position of the Society of Petroleum Engineers, its officers, or members. Electronic reproduction, distribution, or storage of any part of this paper without the written
consent of the Society of Petroleum Engineers is prohibited. Permission to reproduce in print is restricted to an abstract of not more than 300 words; illustrations may
not be copied. The abstract must contain conspicuous acknowledgment of SPE copyright.

Abstract
Many oil fields have gas caps or associated gas. The common approach for these fields is to continue to
produce oil, whilst re-injecting any gas produced, for as long as it is profitable, and then produce gas. This
approach is motivated by the belief that it will maximize the oil reserves and thus maximize the overall
value of the field.
In this paper we show why maximizing the length of profitable oil production does not necessarily
create the most value. The analysis also provides guidance and insight on operating decisions that would
not be obtained through a more conventional approach.
In this paper we show how a real options valuation approach can be used to determine the optimal
blowdown decision. The approach we take is to re-inject gas to maintain oil production only until the time
it is more financially valuable to produce gas and thus blow-down pressure support for oil production. To
model price uncertainty we use correlated two-factor price processes. We also consider, uncertainties in
oil and gas reserves and production as well as in transition costs. The model is solved using the
Least-Squares Monte Carlo simulation approach. We use a material balance simulator, which is embedded
into the underlying model, to represent the oil and gas production.
We illustrate how the approach can be used to identify optimal blowdown time, and thus maximize
value, for a North Sea based oil field with associated gas.
Our results indicate that the value-maximizing blowdown time is different than would be computed
using traditional net present value. Furthermore, the approach we take in this paper yields a decision-
policy “map” that indicates the optimal choice given the state of oil prices, gas prices, production rates,
costs, and remaining reserves in any given year.
The results presented here are relevant and applicable to oil and oil/gas fields across the world.
Calculating the optimal blowdown time is not straightforward as it is a function of the underlying
uncertainties such as oil and gas prices, their co-variation, oil and gas reserves and production, blowdown
costs, and technology improvements, and its calculation is not trivial. However, ignoring these uncer-
tainties leads to sub-optimal blowdown decisions, resulting in significant value losses.

Introduction
Many producing oilfield have associated gas or gas caps. A common strategy in producing these fields is
to reinjecting the produced gas to provide pressure support for oil production. When the oil production
2 SPE-174868-MS

ceases to be profitable, the produced gas is no longer reinjected but sold in the spot market or through long
term contracts. Stopping the the gas injection usually leads to a rapid pressure loss in the reservoir which,
in turn, effectively removes the gas drive (solution and cap) supporting the oil production. As a result, the
oil production declines beyond what would have been the case if gas had continued to be reinjected. The
logic behind this approach is that if we maximize the oil recovery, we will maximize the overall value of
the field.
Some authors (Uwaga and Lawal 2006; Garimella, et al. 2010) have discussed and proposed methods
to minimize oil production losses during the gas blowdown period. The approach we take in this paper
is based on a different logic. Given the uncertainty in future oil and gas prices, we want to identify the
optimal oil-gas production and price configurations required to initiate gas production. That is, given the
price uncertainties, at what point in time will it be more valuable to BD the field by lifting the gas rather
than reinjecting it. An effective way to assess this is to formulate the switching time as a real option; we
need to value the option to blowdown (BD) at each time period and compare it with the value resulting
from continuing the gas reinjection and sell oil only. As we will illustrate, initiating the BD at the optimal
time, as opposed to maximizing the oil production, will maximize the overall value of the field.
Identifying the optimal BD time requires a model which includes relevant and material uncertainties,
allow for learning over time, and dynamic flexibility. Although flexibility is often acted upon in the oil
& gas industry, its value is not usually quantified (Begg, et al. 2002; Karakaya 2012). Developing, using,
and communicating the results from these types of models requires deep knowledge and understanding of
both the technical issues involved in the problem as well as of the corporate finance aspects. This
flexibility valuation problem is basically a problem of investment under uncertainty, and the real options
(RO) approach has been shown to be an efficient optimization technique.
The RO approach is a method to evaluate the value of real assets using a financial options valuation
framework. Although the analytical methods to solve RO problems can be quite involved (Dixit and
Pyndick 1994), relatively simple numerical methods have are also available. In this paper, we use the
Least-Squares-Monte Carlo (LSM) algorithm developed by Longstaff and Schwartz (2001). LSM is very
versatile and efficient and does not, to the same extent as lattice and decision tree methods, suffer from
the “curse of dimensionality” as it is relatively insensitive to the number of uncertainties in the problem.
It is now frequently used outside the oil & gas industry and an increasing number of papers have also
demonstrated its usefulness in oil and gas contexts (Smith 2005; Hem, et al. 2011; Willigers, et al. 2011;
Alkhatib and King 2011; Jafarizadeh and Bratvold 2012, 2013).
Two previous papers are particularly relevant for the BD timing option are Hahn and Dyer (2008) and
Hem, et al. (2011). Hahn and Dyer (2008) present the development of binomial lattices for approximating
mean reverting stochastic processes. They include an example of their mean-reverting binomial lattices
focused on valuing the BD option by treating it as a switching option. Since they apply two correlated
mean-reverting processes, they implement a bivariate binomial approximation to represent the correlated
processes. Hem, et al. (2011) present and discuss the use of the LSM algorithm for the switching options
problem. They use decline curves to describe the hydrocarbon production and determine the value of
switching from oil only production to gas only production where the oil and gas prices are uncertain.
This paper extends these previous publications. Instead of calculating the value of switching from oil
to gas production, we calculate the optimal BD time and its value. And, instead of using binomial
approximations, we use the more versatile LSM algorithm. A material balance simulator is used to model
the oil and gas production scenarios. Although both oil and gas is produced up to the BD time, only oil
is sold and the gas is reinjected. When the BD decision has been made, again both oil and gas is produced
but now both hydrocarbon streams are being sold in the spot market. The approach used in this work
provides not only the value of the BD option but also generates a decision-map; i.e., a map of the optimal
BD time given the time-evolution of the underlying uncertainties. Price uncertainties are modeled by using
a two-factor price model (Schwartz and Smith 2000), calibrated to forward data using a Kalman Filter.
SPE-174868-MS 3

In this paper, we describe an approach for modeling and assessing value creation from uncertainty and
flexibility in an oil & gas context. The approach is real options based and explicitly accounts for the
relevant and material uncertainties, the value of learning, and dynamic decision making. We demonstrate
this approach using the BD example. This example combines price uncertainties with a Darcy Law-based
production model in a RO framework and demonstrates the value of learning about the uncertainties (from
observing the actual outcomes at each time step) when choosing a BD strategy. We also compare and
contrast this cogent model with a naïve, but perhaps more intuitive, approach for determining the optimal
BD time and value.
The paper is organized as follows: The next section describes the problem statement and the oilfield
properties that we use as a reference throughout this paper. Next, we describe the production model for
the field. The following section then describes the price process and its calibration. We then discuss,
compare, and contrast two solution approaches for valuing the BD problem; the naïve approach and the
RO approach. Finally, we close the paper with conclusion and discussion.
Problem Statement
An oil company is evaluating whether to develop an oilfield with significant associated gas — both in the
form of solution gas and a gas cap. The assessed properties of the field are listed in Table 1. Prior to
submitting the Plan for Development and Production (PDO) for sanctioning, the company needs to assess
the value of the field. Based on their understanding of the field characteristics, the company experts have
proposed to install top-side capacities such that the production is constrained to a maximum rate of 10000
STB/Day. This oil production rate is expected to be attained in year 5 since production is started.

Table 1—Reservoir parameters

Reservoir Pressure 4350 Psig
Oil in Place 175 MMSTB
Solution GOR 887 SCF/STB
Gas Cap Volume 173.6 BSCF

There is infrastructure and pipelines with spare capacity nearby but their maximum spare capacity is
estimated to be 75 MMSCFD. If gas is being lifted, it will be sold at the prevailing market rate. However,
in order to hook up to the existing infrastructure, the company needs to invest $100 MM for the connecting
pipeline and for installation of additional surface facilities. Both of these are categorized as BD costs.
Furthermore, if the company decides to BD the field, it will be done gradually. BD initiation will decrease
the reinjection rate annually in increments of 25% from the total gas production. This means in the 4th year
after BD, there will be no further gas reinjection. The company use a risk-free rate of 5%.
Given these assessments, when is the optimal time for the company to stop the gas reinjection and BD
the field by lifting and selling the gas? Furthermore, what is the value of the BD flexibility; i.e., the option
to initiate BD in any year, for this field?
Production Model
The field will be producing both oil and gas from day one. However, all of the produced gas is reinjected
until BD time. A material balance simulator linked with a well simulator, and a surface network solver
is used to forecast the production. The maximum field life is assumed to be 46 years. The decision to BD
the field is being evaluated on an annual basis. However, due to regulatory constraints gas cannot be lifted
in the first 10 years. Furthermore, there is a requirement for a minimum of 5-years of gas supply if it is
decide to sell it.
4 SPE-174868-MS

Based on these conditions, 33 possible production profiles are generated: one no blowdown (nBD)
scenario and 32 scenarios where the BD is being initiated at the end of year 10 through the end of year
41. Four of these forecasted production profiles are shown in Fig. 1 (oil) and Fig. 2 (gas).

Figure 1—Oil production profile for blowdown (BD) at year 15, 25, 35 and no blowdown (nBD) scenarios.

Figure 2—Gas production profile for blowdown (BD) at year 15, 25, 35 and no blowdown (nBD) scenarios.

Figs. 1 and 2 illustrate how the simulated production profiles capture the effect of the gas BD. When
the gas is being lifted the pressure support for the oil production is rapidly reduced and the oil production
decline increases compared with the nBD case. Although the oil production declines, additional income
is obtained from the gas sales. The analysis presented and discussed in this paper is decision oriented:
Given the decision-makers current state of knowledge, what is the optimal BD time when the goal is to
maximize the financial return from the field?
Price Process
It is well recognized that oil price uncertainty is one of the main factors that drive uncertainty in economic
value assessments used to make decisions in oil &gas companies. Any evaluation of oil & gas based
investment opportunities should therefore include a dynamic price model — one that replicates the
characteristics of real price fluctuations as a function of time, not just the mean price. There is a rich
SPE-174868-MS 5

literature on oil price modeling and much of it has been motivated by the desire to improve the quality
of investment valuation and decision making under price uncertainty. In this paper, we model the oil price
using the Schwartz and Smith (2000) two-factor price process. The model provides advantages over more
basic methods but is still simple enough to be communicated to corporate decision makers, who are
generally not experts in financial modeling or option theory. The balance between realism and ease of
communication of the model has governed the choice of this model in favor of both one-factor models,
in which the equilibrium level is assumed to be constant, and multi-factor models with three or more
factors.
The Schwartz and Smith (SS) model allows mean-reversion in short term prices and uncertainty in the
long-term equilibrium level to which prices reverts. The equilibrium prices are modeled as a GBM
process, reflecting expectations of the exhaustion of existing supply, improved exploration and production
technology, inflation, as well as political and regulatory effects. The short-term fluctuations reflect the
vanishing of the difference between the spot and equilibrium prices. They are modeled as a one-factor
mean-reverting process. These short-term deviation reflects short-term changes in demand, resulting from
intermittent supply disruptions, which are eased by the adjustment of production levels made by the oil
producers. We will value the BD option using risk-neutral pricing and will thus need the risk-neutral price
process to describe the dynamics of the oil and gas prices. The cash flows are then discounted using the
risk-free rate. The short-term and equilibrium components in the risk-neutral version of the two-factor
model are:
(1)

(2)

where and are the increments of standard Brownian motion processes with
. Eqs. 1 and 2 are expressed in log terms and the price, St is given by:
(3)

The long-term factor, ␰t is a function of its drift (␮␰), risk premium (␭␰) and standard deviation (␴␰).
The short-term factor, ␹t is a function of its mean-reverting factor (k), risk premium (␭␹), and standard
deviation (␴␹). To simulate the price process, we use the discretized version of the stochastic differential
equations (SDE). Both Jafarizadeh and Bratvold (2012) and Davis (2012) discuss how to discretize the SS
model, and although there are differences in the discretization of short-term and long-term factors in those
papers, they converge to the same simulated prices. In this work, we use the discretization scheme
presented by Jafarizadeh and Bratvold (2012). The discretized forms of the long and short term
components are
(4)

(5)

where ␧␰ and ␧␹ are standard normal random variables. The short and long term processes are correlated
in each time period through the correlation coefficient (␳␹␰). Furthermore, as oil and gas prices tend to be
correlated, we also need to include the correlation matrix relating the short and long term components of
the oil prices to those of the gas prices.
Calibration. Before using SS model, a decision must be made on how to determine the parameters of
the model. This process is known as calibration. In general, the choice of price process and calibration data
should reflect the decision-maker’s uncertainty (lack of knowledge) about future prices. In this work we
6 SPE-174868-MS

assume that the operating company is public and that its shares are being traded on a public stock
exchange. We should then capture the market’s view on the uncertain future oil and gas prices. The market
view of the future prices are embodied in futures contracts that are traded in the market. Using the SS
model, we can value a futures contract by calculating the expectation of the spot prices at the maturity time
T using the equation
(6)

(7)

where FT, 0 denote the market price at time 0 (current) for a futures contract with maturity time T. As
seen from Eqs. 6 and 7, there are 7 parameters (␮␰, ␭␰, ␴␰, k, ␭␹,␴␹,␳␹␰) to be determined for the oil prices
model and another 7 for the gas price model. In addition to these 7 parameters, we also need the initial
long-term and short-term factors (␰0,␹0). In total, there are 9 parameters for oil price model and another
9 variables for gas price model that needs to be determined through calibration. As oil and gas prices tend
to be correlated, we will also need to use relevant data and information to determine appropriate
correlation coefficients between the two price models.
The long-term and short-term factors in the SS model are not directly observed in the market. We
observe only spot, futures, and option prices. To get the unobservable factors, we need to estimate the
unobservable variables based on observations that depend on these variables. In this paper, we use the
Kalman Filter (KF) approach to filter the prices of futures contract into its long-term and short-term
factors. We wrap KF around maximum likelihood routines so that we maximize the log-likelihood score
to estimate the 7 parameters required for simulation of each of the two prices. The 7 parameters that gives
the maximum log-likelihood scores are then chosen as our calibrated parameters. This approach also gives
us the filtered long-term and short-term factors of the most recent data. We use these as the initial
long-term and short-term factors. Further details on Kalman Filter approach are discussed in Schwartz and
Smith (2000), Andresen and Sollie (2013), Hahn, et al. (2014), and Thomas and Bratvold (2015).
For our calibration, we use the yearly average of WTI futures prices and the yearly average of Henry
Hub futures prices from 1992-20151. Specifically, for each year, we observe 6 prices of futures contracts
maturing in 1, 3, 5, 9, 13 and 17 months. Figs. 3 and 4 displays observed and simulated futures prices
using the calibrated parameters. We see that for both natural gas and oil, the simulated price results closely
resemble the observation. The parameters resulting from calibration are listed in Table 2.

1
For 2015, we use data up to March 12th to calculate the average yearly prices.
SPE-174868-MS 7

Figure 3—SS model calibration for natural gas prices.

Figure 4 —SS model calibration for oil prices.

8 SPE-174868-MS

Table 2—SS model parameters from calibration

Parameter Oil Natural Gas

␬ 1.07 1.56
␴␹ 0.25 0.38
␹0 ⫺0.34 ⫺0.22
␭␹ 0.08 0.02
␮␰ 0.05 0.04
␴␰ 0.19 0.17
␰0 4.20 1.17
␭␰ 0.08 0.06
␳␹␰ 0.34 0.75

It has been demonstrated that natural gas and crude oil have been historically related (Villar and Joutz
2006; Brown and Yucel 2008) and we need to assess how the oil and gas time series are correlated. Having
estimated the time series for crude oil and natural gas, we have a total of four time series. To estimate the
correlations between the time series, we correlate the scaled increments2 of the state variables obtained
from the KF. Fig. 5 shows the resulting correlation matrix between the four time series.

Figure 5—Oil and gas price correlation matrix.

The solid lines in Figs. 6 and 7 show a simulated price path using the parameters in table 2. The dashed
lines are the P10 and P90 “confidence bands.” These confidence bands show that at a specific time, there
is a 10% and 90% chance (respectively) that the prices fall below that amount.

2
From the Kalman filter, we obtain both short-term and long-term factors of the prices. We then normalize both factors into their scaled increments which
are ␴␹␧␹ for short-term factor and ␧␰␴␰ for long-term factor. See Andresen & Sollie (2013) for more details.
SPE-174868-MS 9

Figure 6 —Oil price probabilistic forecast.

Figure 7—Gas price probabilistic forecast.

Figs. 6 and 7 also illustrate the “learning nature” of the SS price process. At time 0, the market’s beliefs
about the range of possible oil and gas prices are shown by the first set of dashed lines. Then, fast
forwarding 20 years into the future, we learn that the actual oil price is $26.5 and the actual gas price $2.3.
The market’s updated beliefs are indicated by the second set of dashed lines. As we can see, a lower price
at any point in time leads the market to believe that the future range of possible prices will be narrower
than at time 0. As will be shown later, the ability to specify how we learn as a result of receiving new
information is an essential feature of the optimization algorithm employed.
Solution Approaches
In the following discussions, we will discuss two different approaches to solving or optimizing the BD
problem. The first, naïve approach, the optimization of BD timing decision is based on the use of scenario
analysis, which suggests the optimal BD time is found by sequentially evaluating all possible BD times.
The second, RO approach, is dynamic in that the optimal timing will change for each iteration in the MCS.
10 SPE-174868-MS

Naïve Approach
A naïve, but perhaps intuitive, approach to optimizing the decision problem is to apply simple scenario
analysis. The BD problem presented here has 32 possible BD decision points — year 10 through 41.3 The
optimal BD time is estimated by sequentially testing each of the 32 scenarios; i.e., for each of the 32 cases,
we a priori impose a BD time, ␶␧ [10, 41] and use Monte Carlo Simulation (MCS) to calculate the Net
Present Value (NPV). The NPV for a given BD time, ␶, is given by
(8)

The first term on the right-hand-side of Eq. 8 represents the NPV from oil production, the second term
NPV from gas production starting with the first year after the BD decision, and the final term the one-off
costs required to implement the BD. Up through BD time, both oil and gas are being produced but only
oil is sold. From the first year after BD to the end-of-field life both oil and gas are being produced and
sold. Fixed costs, variable operating costs, and initial investment costs are not included in the calculation
as these costs will be incurred regardless of when the BD decision will be made. Eq. 8 is used to calculate
the NPV for every iteration in the MCS.4 The subscript t denote years, the time period of the simulation.
qoil,t and qgas,t denote the production of oil and gas, respectively, in year t, and is obtained from the
material balance simulator as discussed earlier. qgas,t refers to gas produced and sold and does not include
gas produced and reinjected. Thus, qgas,t ⬎ 0 when t ⱖ ␶ ⫹ 1. k the cost required to implement the BD,
occurs once at time t ⫽ ␶ and is set to $100 MM. End-of-year discrete-time discounting is being used and
denotes the risk-free discount rate5. For each MCS iteration, the value of the BD option is given by the
difference between the value with BD, NPV␶, i and the value without the BD option, NPVnBD
(9)

and the expected incremental value from the BD is given by E[⌬ NPV␶].
For comparison purposes it is useful to illustrate the steps in the naïve approach through a schematic
decision tree model as shown in Fig. 8. The decision node on the far left side represents the scenario
analysis decision; i.e., the sequential testing of each of the possible BD times ␶␧ [10, 41]. The chance node
at each time step represents the time series for oil and gas prices; i.e., the uncertainties considered in the
BD model. With a large enough number of MCS iterations, the uncertainty nodes are, for all practical
purposes, continuous as indicated by the arcs in the uncertainty nodes.

Figure 8 —Decision tree for BD decision with conventional approach

Starting the process, we set, ␶ ⫽ 10 run the MCS, calculate the NPV for each iteration and store the
E[⌬NPV␶] corresponding to ␶ ⫽ 10. We then repeat the steps for ␶ ⫽ 11 through ␶ ⫽ 41. The BD time,
␶, corresponding to the maximum E[⌬NPV␶] is the optimal BD time.

3
We use the end-of-year convention.
4
The MATLAB model use Monte Carlo sampling with N ⫽ 500,000 as we found this to give stable results for the expected value and variance. See
Raychaudhuri (2008) for more details regarding MCS result assessment.
5
We are using a fully risk-neutral valuation approach. Using full risk- neutrality, sometimes referred to as “market-based valuation” or “state-pricing,” implies
that we should only use the discount the cashflows for time as risk (uncertainty) is explicitly included in the cashflow elements. This discounting for time is
achieved through the use the risk-free rate. A common choice for the risk-free rate is the LIBOR rate — the average interbank interest rate at which a selection
of banks on the London money market are prepared to lend to one another. See Laughton et al. (2008) for an in-depth discussion of the risk-neutral approach.
SPE-174868-MS 11

Why is this a naïve approach to optimizing the problem? Two reasons. First, in reality, the firm’s view
on future oil and gas prices is likely to change over time as the decision makers will have more
information and knowledge in years 10 through 41 than they have in year 0. Secondly, the naïve approach
does not include the value and impact of future (from any year they evaluate the decision) decisions. The
learning over time leads to an updated understanding is likely to change the decision of whether or not
to BD in any given year. The flexibilities to do so are not captured in the naive approach.
Real Options Approach — Least Squares Monte Carlo
In the real options (RO) approach, we explicitly include all of the decision makers’ flexibilities. The
schematic decision tree in Fig. 9 captures all previously un-modeled options as well as the key
uncertainties and is a more realistic representation of how these decisions are actually made. The resulting
model is significantly “richer” than the “decide now” tree depicted in Fig. 8.

Figure 9 —Decision tree for BD decision with real options

As with the naïve approach, the first step in applying the RO approach is to run a MCS to account for
uncertainties. The MCS results are then used to calculate the expected NPVs for any decision policy.
Remember from the earlier price models discussion that the uncertainties in Figs. 8 and 9 are dependent,
and thus, include sequential “learning” from one time-step to the next; i.e., the probability of any
uncertainty at time t ⫹ 1 is conditional on the outcome of the uncertainty at time t.
The next step is to calculate an optimal decision policy; i.e., to find the optimal path through the
decision model. We do this by inserting decisions into the model as shown in Fig. 9. Finally, given the
optimal decision policy, we calculate the expected NPV of the project using this decision policy. The
resulting NPV includes the elements missing from the naïve approach: the impacts of learning and a
dynamic decision policy.
To calculate the optimal decision policy at each decision point, we need to examine the expected future
NPV for each decision alternative, conditioned on the resolution of the uncertainties up to that time. The
optimal policy then selects the alternative with the maximum value in a given information state. This is
how decision trees are solved by the roll-back procedure and is also how the recursive optimization
approach called dynamic programming (DP) works (Howard 1960; Dixit and Pindyck 1994). For a small
problem with a small number of discrete outcomes, this recursive algorithm works fine. However, for a
more realistic problem, such as the BD context, there will be billions of possible paths through the
decision model resulting from different combinations of uncertainty node outcomes and decisions. In an
attempt to overcome these challenges, Longstaff and Schwartz (2001) introduced an approximate
approach to the DP implementation; the Least Squares Monte Carlo (LSM) approach.
LSM Algorithm. Although the LSM algorithm has been extensively used for valuation problems
outside oil and gas, there are only a handful of papers applying and discussing it within the oil and gas
literature domain. Smith (2005) use LSM to evaluate divestment and expansion options for an oilfield.
Willigers and Bratvold (2009) and Jafarizadeh and Bratvold (2012) use LSM to illustrate the value of
abandonment flexibility. Jafarizadeh and Bratvold (2013) also apply the LSM implementation for the
storage option. LSM is very versatile and efficient and does not, to the same extent as lattice and decision
tree methods, suffer from the “curse of dimensionality” as it is relatively insensitive to the number of
12 SPE-174868-MS

uncertainties in the problem. However, its complexity grows with the number of decisions and alternatives
in the problem, the same way as decision trees.
In the LSM algorithm, the value for each decision alternative is approximated by using linear
regression. We then use these estimated regression equations to determine the near-optimal decision
policy. Starting with the last decision in the model, t ⫽ N, we know the prices at that time and simply
choose the alternative with the highest value (from the MCS). For all other time steps, t ⬍ N, we know
the oil and gas prices at that time and use the expected continuation values as a function of the prices at
that time. The expected continuation is approximated from the MCS results by recording the NPV at time
t ⫹ 1 of the cashflows in each MCS iteration. We then run a regression relating the realized continuation
values to the year oil and gas prices.
For the BD problem, if the decision is to not BD the field at time , the firm gets the continuation value
CVt ⫹ 1 (St ⫹ 1) whilst if the decision makers decide to BD at time t, the firm gets the BD value BVt ⫹ 1
(St ⫹ 1). At time t, both CVt ⫹ 1(St ⫹ 1) and BVt ⫹ 1(St ⫹ 1) are random variables. We denoteEt [CVt ⫹ 1(St
⫹ 1)] the conditional expectation value at time t for continuation in the nBD alternative and Et [BVt ⫹ 1(St
⫹ 1)] the conditional expectation value at time t for the BD alternative.
When the firm evaluates the BD decision at time t, the oil and gas prices at time are known whilst all
prices for times greater than are still unknown. We then run a regression relating the realized continuation
values CVt ⫹ 1(St ⫹ 1) and BVt ⫹ 1(St ⫹ 1) to the year oil and gas prices. We use regression equations where
the two expected continuation values are:
(10)

and
(11)

where
(12)

and
(13)

where and represent the oil and gas production profiles in the BD period and all other
terms have been defined earlier. The interpretation of Eq. 12, representing the continuation value in the
nBD case (␶ ⫽ ⬁) is straightforward. Eq. 13, representing the BD value, contains the BD oil and gas
production profiles as well as the cost of implementing the BD scheme. The last term in Eq. 13 denotes
the losses incurred by initiating the BD scheme. By choosing to BD the field, the decision makers forego
the possibility to continue to produce the oil and reinject the gas; i.e., the nBD scenario. The value of
choosing to BD must therefore include this lost opportunity.
Although the linear terms used in the regression equations (Eqs. 10 and 11) are sufficient in this case,
we could easily include additional terms. If there are additional uncertainties in the problem that might
affect these conditional expectation values, we can simply add additional basis functions, linear or
non-linear, to the regression model.
The regression equations provide an approximation of the expected values for each of the two decision
alternatives as a function of the year t state variables and are used to determine a near-optimal decision
policy. With any realized state of the uncertainties at time t, we calculate the estimated expected
SPE-174868-MS 13

continuation values Ct and Bt from the values of the oil and gas prices generated in that realization using
the regression equations as shown in Eqs. 10 and 11. If the expected BD value at time t exceeds the
expected nBD value at time t, then the firm should initiate the BD scheme.
Simulating using the identified near-optimal decision policy, we will find the expected value with the
BD option. And the difference between this and the value with nBD option represent the value of the BD
option.

Results
Fig. 11 shows the relative frequency for the value of the option to BD the field at any time between year
10 and year 41, inclusive. The expected value of the option is $104 MM.6

Figure 10 —Value of the BD option

6
As discussed earlier in the paper, the value is incremental to the case without this option.
14 SPE-174868-MS

Figure 11—Relative frequency of the optimal BD time

There is a 7% chance of losing money (relative to the nBD option case) by blowing down the field.
There are two reasons why the dynamic flexibility implemented in the model does not preclude a negative
outcome. First, the model does not include the option of reverting the BD decision or closing down the
field before year 46. In some cases, even though the BD decision looked good at the time it was made,
the realized prices ended up being too low to yield a positive incremental NPV. Secondly, recall that the
LSM algorithm is approximate; i.e., near-optimal. In a very small number of cases, a suboptimal decision
will be made.
Fig. 11 shows the relative frequency that any given year will be the optimal year to initiate the BD
scheme. The small graph in the upper right corner shows the field life period from year 10 through end
of life. The tall bar at the far right side in the graph represents the probability (30%) that it never will be
optimal to produce and sell the gas. The larger graph represents the 70% of the cases where BD is optimal
and then indicates the year when it will be optimal to make the BD decision.
How do these results compare with the values and decisions resulting from implementing the naïve
approach? Fig. 12 shows the value histograms resulting from using both the RO approach and the naïve
approach (with BD at year 27) to optimizing the BD problem.
SPE-174868-MS 15

Figure 12—Value of the BD option resulting from the RO approach and naïve approach with BD at year 27

Not surprisingly, the naïve approach results in an almost five times greater chance (34%) of a negative
NPV. One of the benefits of the RO approach is that it adapts to the actual learning taking place over time
so that the decision makers can react and respond to both good and bad news in response to the prevailing
uncertainties. In this case, this ability will protect the decision makers from a significant downside
compared with the naïve approach.
Fig. 13 shows the value of the BD option as a function of BD year resulting from the naïve optimization
approach. Again, if the field is being blown down too early, the value is negative. The BD value does not
change much in the range of 22 — 32 years (the absolute optimum is year 27 with a value of 69.05) but
declines rapidly after year 32. The rapid decline in value is due to the fact that if the BD is delayed beyond
year 32, a increasing amount of gas will never be produced. Note that these results are based on the
assumption that we decide on the BD year a priori, using only the information and knowledge we have
at the time of the sanctioning decision.
16 SPE-174868-MS

Figure 13—E[⌬ NPV␶] as a function of BD time

The RO approach also provides an estimate of the expected BD and nBD values as a function of the
oil and gas prices in any given year. This information can be used to determine a near-optimal decision
policy. To illustrate, consider the decision in year 25. In the MCS at t ⫽ 25, we found the following
estimated conditional expectation values for the nBD (C25) and the BD (B25) cases:7
(14)

(15)

Fig. 14 shows how these regressed surfaces can be used to generate a decision map displaying the
estimated BD and nBD values as functions of year 25 oil and gas prices. For scenarios with high oil and
low gas prices, the firm should continue in the nBD mode. For intermediate prices, the strategies intersect
and, depending on the exact prices at that time, either the BD or nBD alternative will be optimal.

7
From Eq. 14, not surprisingly, we see that the oil price contributes the most to the nBD value. Similarly, from Eq.15, we see that the gas price contributes
the most to the BD value. We also see that in both equations, the regressed constant for the cross products are negligible. This shows that both the BD and
the nBD values are, effectively, a functions of the oil and gas prices.
SPE-174868-MS 17

Figure 14 —3d strategy map for year 25

Fig. 15 shows the decision maps for four different time periods where red indicates that the nBD
alternative is optimal and the blue that the BD alternative is optimal. As time progresses, an increasingly
large portion of the decision map favors the BD choice. This is consistent with the late life declining
nature of the oil production and, hence, its value.

Figure 15—Decision maps for different time periods.

Similar decision maps can be generated for any year and as we progress in time, the maps can be
updated using actual observed prices. Using the RO approach, we are not only able to assess the optimal
decision today but also the optimal future decisions for the range of price scenarios investigated.
This example illustrates the value creating benefits resulting from the interaction of uncertainty and
flexibility. Many oil producing projects may benefit from switching from oil to gas production, to BD the
18 SPE-174868-MS

field, at some point in the life of the field. Decision makers in the oil and has industry fully realize that
there is value in having the flexibility to do so. However, the challenge has been to (1) quantify the value
and (2) determine the optimal time to initial the switch.
Although the naïve approach may be intuitive, it is doing a poor job in modeling how BD decisions
are actually being made. Ignoring the fact that uncertainties gets resolved or reduced over time and that
decision makers implement their decision policies dynamically leads to a significant underestimation of
the value associated with the BD timing flexibility. Furthermore, the naïve approach will, in general, lead
to a sub-optimal timing of the BD implementation.
Unlike the naive approach, the RO approach implements a more realistic model, which in turn, leads
to improved valuation and more optimal decision making. Consider an extension of our example where
there are additional costs of the order of $70 MM required to BD the field. If the naïve approach is being
used to model the decision, the BD flexibility has no value, and thus, will not be pursued. This is clearly
suboptimal and value destroying as the value resulting from a more realistic modeling approach will be
higher.

Conclusions and Discussion

In this paper, we have shown how to determine the optimal BD time for an oil field with a gas caps or
associated gas. We have applied two different solution approaches, the naïve and the real option, and have
concluded that the naïve approach leads to an oversimplification of learning and decision making over
time, which in turn, leads to an unrealistically low assessment of flexibility value.
Unlike in the naive approach, in the RO model, the decision makers are proactively making decisions
in response to their observations of the outcomes of the uncertainties over time. This is a more realistic
model in the sense that it better mimics actual information gathering and decision making. This, in turn,
leads to improved valuation and more optimal determination of the best BD time. In addition to provide
the optimal BD time and its resulting value, the RO approach can also be used to generate optimal, or
near-optimal, decision maps showing future decisions conditional on future oil and gas prices.
In this paper, we illustrated and discussed how to implement the LSM algorithm to optimize the RO
problem. The LSM algorithm is relatively insensitive to the number of uncertainties in the problem and
avoids the curse of dimensionality concerning these uncertainties.
In this paper, the main focus is the implementation of the LSM algorithm to a moderately complex real
options problem. We have not includes any uncertainties related to oil and gas production nor uncertain-
ties related to the BD costs. Nevertheless, the LSM algorithm is extendable to include these uncertainties
as well as any other which may have a material impact on the option value.
Although RO approach has many advantages, it is not a magic bullet for simplifying any complex
problem. The implementation of LSM algorithm involve forward simulation and dynamic programming
which makes it rather complex and not nearly as straightforward as implementing the naive approach.
Even though it is relatively insensitive to the number of uncertainties in the problem, its complexity grows
with the number of decisions and alternatives in the problem in the same way as decision trees. However
we found that the information and value gained from implementing LSM offset its implementation costs
by a large magnitude. Having worked on a number of RO and LSM implementations, we have developed
a set of software modules, which are easily ported to a new problem making the development of a new
model relatively easy. All in all, we have shown that using the real options framework as described in this
paper leads to near-optimal valuation and decision making when compared with a naïve approach. In the
BD context, we have demonstrated that significant value can be created from the uncertainty and
flexibility if this upside potential is recognized and evaluated through the use of a realistic and consistent
model.
SPE-174868-MS 19

Acknowledgements
We would like to thank Steve Begg for engaging in many conversations regarding both real options
valuation in general and the specific characteristics of the blowdown timing problem. He has undoubtedly
contributed to our current thinking and understanding of the topics discussed in this paper.

References
Alkhatib, A. M. and King, P. R. 2011. Applying Real Options Theory in Determining Optimal Policies
for a Surfactant Flood. Presented at the SPE Enhanced Oil Recovery Conference, Kuala Lumpur,
Malaysia, 19-21 July. http://dx.doi.org/10.2118/144869-MS.
Andresen, A. and Sollie, J. 2013. Multi-Factor Models and the Risk Premiums: A Simulation Study.
Energy Systems 4 (3): 301–314. http://dx.doi.org/10.1007/s12667-013-0080-6.
Begg, S., Bratvold, R. and Campbell, J. 2002. The Value of Flexibility in Managing Uncertainty in Oil
and Gas Investments. Presented at the SPE Annual Technical Conference and Exhibition, San
Antonio, Texas, 29 September – 2 October. http://dx.doi.org/10.2118/77586-MS.
Begg, S. H., Bratvold, R. B. and Campbell, J. M. 2004. Abandonment Decisions and the Value of
Flexibility. Presented at the SPE Annual Technical Conference and Exhibition, San Antonio,
Texas, 26 – 29 September. http://dx.doi.org/10.2118/91131-MS.
Bratvold, R. and Begg, S. 2010. Making Good Decisions, Society of Petroleum Engineers.
Brown, S. P. A. and Yucel, M. K. 2008. What Drives Natural Gas Prices? Energy Journal 29 (2):
45–60. 0967309 Alternate Accession Number: EP32848192. http://dx.doi.org/http://www.iaee-
.org/en/publications/journal.aspx.
Davis, G. A. 2012. Technical Note: Simulating the Two-Factor Schwartz and Smith Model of
Commodity Prices. The Engineering Economist 57 (2): 130 –140. http://dx.doi.org/10.1080/
0013791X.2012.677302.
Dixit, A. K. and Pindyck, R. S. 1994. Investment under Uncertainty, Princeton University Press.
Gamba, A. 2002. Real Options Valuation: A Monte Carlo Approach. Social Science Research
Network Working Paper Series. http://dx.doi.org/http://dx.doi.org/10.2139/ssrn.302613.
Garimella, S. V. S., Kalbani, A., Waili, I. H., et al. 2010. Gas Blowdown Case Study: Striking a Fine
Balance between Maximizing Gas Production Plateau and Minimizing Oil Loss. Presented at the
SPE EUROPEC/EAGE Annual Conference and Exhibition, Barcelona, Spain, 14 –17 June. http://
dx.doi.org/10.2118/130596-MS.
Hahn, W. J., DiLellio, J. A. and Dyer, J. S. 2014. What Do Market-Calibrated Stochastic Processes
Indicate About the Long-Term Price of Crude Oil? Energy Economics 44 (0): 212–221. http://
dx.doi.org/http://dx.doi.org/10.1016/j.eneco.2014.04.007.
Hahn, W. J. and Dyer, J. S. 2008. Discrete Time Modeling of Mean-Reverting Stochastic Processes
for Real Option Valuation. European Journal of Operational Research 184 (2): 534 –548.
http://dx.doi.org/http://dx.doi.org/10.1016/j.ejor.2006.11.015.
Hem, ø. D., Svendsen, A., Fleten, S.-E., et al. 2011. The Option to Switch from Oil to Natural Gas
in Active Offshore Petroleum Fields. Presented at the Annual International Real Options Confer-
ence, Turku, Finland, June 15–18.
Howard, R. A. 1960. Dynamic Programming and Markov Processes, 1st edition, The MIT Press.
Jafarizadeh, B. and Bratvold, R. 2012. Two-Factor Oil-Price Model and Real Option Valuation: An
Example of Oilfield Abandonment. SPE Econ & Mgmt 4 (03): 158 –170. http://dx.doi.org/
10.2118/162862-PA.
Jafarizadeh, B. and Bratvold, R. 2013. Sell Spot or Sell Forward? Analysis of Oil-Trading Decisions
with the Two-Factor Price Model and Simulation. SPE Econ & Mgmt 5 (03): 80 –88. http://
dx.doi.org/10.2118/165581-PA.
20 SPE-174868-MS

Karakaya, E. 2012. Perceived Value and Popularity of Decision Analysis Tools in Upstream Asset
Valuations. Presented at the SPE Hydrocarbon Economics and Evaluation Symposium, Calgary,
Alberta, Canada, 24 –25 September. http://dx.doi.org/10.2118/162675-MS.
Laughton, D., Guerrero, R. and Lessard, D. 2008. Real Asset Valuation: A Back-to-Basics Approach.
Journal of Applied Corporate Finance 20 (2): 46 –65. http://dx.doi.org/10.1111/j.1745-
6622.2008.00180.x.
Longstaff, F. and Schwartz, E. 2001. Valuing American Options by Simulation: A Simple Least-
Squares Approach. Review of Financial Studies 14 (1): 113–147. http://dx.doi.org/10.1093/rfs/
14.1.113.
Luehrman, T. A. 1998. Investment Opportunities as Real Options: Getting Started on the Numbers.
Harvard Business Review 76 (4): 51–67. 780213.
Luiz, E. B., Dyer, J. S. and Hahn, W. J. 2005. Using Binomial Decision Trees to Solve Real-Option
Valuation Problems. Decision Analysis 2 (2): 69 –88. 205849554.
Raychaudhuri, S. 2008. Introduction to Monte Carlo Simulation. Presented at the 40th Conference on
Winter Simulation, Miami, Florida, December 07–10.
Schwartz, E. and Smith, J. E. 2000. Short-Term Variations and Long-Term Dynamics in Commodity
Prices. Management Science 46 (7): 893–911. doi: http://dx.doi.org/10.1287/
mnsc.46.7.893.12034.
Smith, J. E. 2005. Alternative Approaches for Solving Real-Options Problems. Decision Analysis 2
(2): 89 –102. doi: http://dx.doi.org/10.1287/deca.1050.0041.
Uwaga, A. O. and Lawal, K. A. 2006. Concurrent Gas-Cap and Oil-Rim Production: The Swing Gas
Option. Presented at the Nigeria Annual International Conference and Exhibition, Abuja, Nigeria,
31 July–2 August. http://dx.doi.org/10.2118/105985-MS.
Willigers, B. J. A., Begg, S. and Bratvold, R. 2011. Valuation of Swing Contracts by Least-Squares
Monte Carlo Simulation. SPE Econ & Mgmt. http://dx.doi.org/10.2118/133044-PA.