Value of purchasing information to reduce risk in capital investment projects

Successful investment management of capital-intensive, long-lived energy projects requires an understanding of the economic uncertainties, or risks, as well as the mechanisms to resolve them. Industry traditionally manages these risks by purchasing information (seismic, well testing, appraisal drilling, reservoir simulation, market capacity and price studies, etc.) about the project and making incremental investments as new information reduces the uncertainties to acceptable levels. Traditional discounted cash flow analyses cannot readily deal with valuing information. We suggest that the purchase of information about a project has considerable value and can be treated as purchasing an option on the project. As with options on equities, if the information leads to the expectation of a positive investment outcome, the project should be funded. Similarly, options on capital investment projects also have a time factor dictating value and the proper time to undertake the investment. This article discusses the application of option pricing techniques (OPT) to valuing information. We show how OPT is used to value the information surrounding a production capacity decision for an offshore gas field development. In the example, we value the field development alternatives and the acquisition of incremental information for the alternative selection process. As a further extension of OPT to capital investment projects, we create a dynamic model to identify investment alternatives to capture additional value over the project's lifetime. The dynamic model uses information acquired in development drilling and field operations to maximize the investment outcome.