Comparing Three Methods for Evaluating Oil Projects: Option Pricing, Decision Trees, and Monte Carlo Simulations

Abstract

Abstract Option pricing, decision trees and Monte Carlo simulations are three methods used for evaluating projects. In this paper their similarities and differences are compared from three points of view:- how they handle uncertainty in the values of key parameters such as the reserves, the oil price and costs; how they incorporate the time value of money and whether they allow for managerial flexibility. We show that despite their obvious differences, they are in fact different facets of a general project evaluation framework which has the static base case scenario as its simplest form. Compromises have to be made when modelling the complexity of the real world. These three approaches can be obtained from the general framework by focussing on certainty aspects.

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