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Trading real options analysis course - business cases and software applic - Mun P.D.

Mun P.D. Trading real options analysis course - business cases and software applic - Wiley publishing , 2003. - 318 p.
ISBN 047-43001-3
Download (direct link): tradingohnathan2003.pdf
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Case Studies
panies it has become more economical to buy technical capabilities than to develop them. Additionally, efforts are ongoing with both players trying to wring out any potential inefficiencies that remain from operations.
Nowhere has this capital utilization rationalization process been more apparent and far-reaching than in the area of technology development. The resulting actions have created a shift in technology development that is every bit as dramatic as the great continental rift that broke apart Pangea. Upstream R&D investment over the past decade has been following a downward trend. Furthermore, the R&D load borne by service companies has been increasing annually for the past 30 years. In 1970 service companies accounted for approximately 20 percent of the industry’s R&D spending with the integrated energy companies accounting for the bulk of the remaining 80 percent.6 This work was primarily pure and so-called blue sky in nature. Today, greater than 40 percent of the industry’s R&D spend belongs to the service companies and is application-driven. Currently, there are no indications that this trend will be arrested. Additionally, an increasing portion of the remaining 60 percent is being spread over jointly funded projects that involve service companies, universities, and the integrated energy companies.7 In short, energy companies have elected to focus their efforts on managing their resources so that they may extract the most value from their assets— namely, reserves. They intend to do this by leveraging what is arguably the most valuable asset of the service companies—namely, technology.
Faced with the same capital constraints, service companies must adapt to this rapidly changing and evolving role. Further, this metamorphosis must be managed strategically within the context of an industry that continues to see a significant compression in the periods between business cycles and an increasing amplitude during the cycles. This circumstance means there is an increasing need for developing more expensive technology with greater associated risks and shorter expected product life cycles. This new role and the associated macrofactors previously stated have created problems in risk management, portfolio management, and technology valuation that simply cannot be addressed effectively using traditional methods and techniques. For example, how does one value a new downhole robotic sensor being developed by two ex-service-company engineers in their garage that has the potential to totally change the way a North Sea reservoir is produced? Should a large, integrated service company license the rights to the promising technology, buy the technology, develop its own or leap-frog it with the pet project being touted by “Jim’s skunk works group down the hall”? If purchasing is the preferred option, how much is the technology worth today given the fact that its targeted market does not exist today? If everyone in the technology department feels the technology is strategic, yet no matter how much the numbers are massaged the project’s NPV is extremely negative, how can management be convinced to proceed with the project? These are
difficult questions that must be answered amid Wall Street screams for increased capital efficiency.
Real options analysis is quickly becoming a tool through which these types of questions are framed and subsequently answered. It allows one to focus on the strategic pathways inherent in any technology development project instead of the straight-line journey previously used to arrive at a project’s NPV, payback, and IRR. Rather than replacing these metrics, real options analysis coupled with stochastic processes simply adds an increased level of sophistication and robustness into the decision-making process.
As technology development projects get increasingly more difficult, capital gets more scarce, and industry fundamentals become more dynamic, successful integrated service companies must adopt more sophisticated, disciplined, and quantitative processes for their R&D efforts. These systems must be robust, provide great flexibility and bring together all stakeholders—marketing, engineering, and strategic planning. Real options analysis is a very powerful tool that goes a long way toward satisfying these objectives.
1. BP Amoco data taken from “Exploration Frontiers for New Century Determined by Technology, Politics,” OGJ, December 1999.
2. International Energy Outlook 2000, U.S. Energy Information Administration (EIA), 1999.
3. See note 1.
4. Ibid.
5. Dow Jones Industrial Group Averages, Wall Street Journal, February 2000.
6. “Research & Development—New Technology Solves Problems,” Hart’s E&P, October 2002.
7. Ibid.
Indran Purushothaman (, the author of this contribution, is a New York-based corporate finance adviser, specializing in undertaking financial analysis and valuation assignments across a range of investments, including start-ups.
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