Keywords
Certainty equivalent
Managerial flexibility
Expected utility theory
Decision tree modeling
Risk-averse decision-maker
Oil and gas investment strategies
How to Cite
Abstract
Despite the growing use of decision analysis in oil and gas investments, the industry continues to underperform in generating consistent value. Conventional valuation methods often treat uncertainty as a risk to be minimized rather than an opportunity to be exploited, overlooking the strategic role of managerial flexibility, or real options. At the same time, they typically assume risk neutrality, which misrepresents the industry’s inherently risk-averse decision-making culture. Common risk measures such as value-at-risk fail to capture true preferences, leading to distorted valuations and suboptimal decisions.
This study addresses these limitations by integrating Real Options Valuation (ROV) with Expected Utility Theory (EUT) to jointly incorporate flexibility and risk preferences into petroleum project evaluation. The contribution lies in a fully operational workflow that links influence-diagram structuring, probabilistic uncertainty modelling, and certainty-equivalent valuation within a recombining binomial decision tree. The framework is applied to a representative oil production project featuring divestment and buyout options. Risk aversion is represented through an exponential utility function, with project values expressed as certainty equivalents reflecting subjective risk tolerance.
Findings show risk preferences fundamentally alter value and optimal strategy. A risk-neutral decision-maker values the project at $280.9 million, while one with a $20 million risk tolerance values it at $200.2 million. Strategically, the risk-neutral agent continues operations in 50% of scenarios, whereas the risk-averse agent divests in 75%. Sensitivity analysis identifies a tipping point near 30 million USD, beyond which choices converge toward risk neutrality.
Overall, the proposed ROV–EUT framework delivers realistic, decision-consistent valuations and clarifies how flexibility protects downside exposure for conservative firms while enabling opportunity capture for more risk-tolerant ones.
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