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Rational plunging and the option value of sequential investment: The case of petroleum exploration

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  • Smith, James L.
  • Thompson, Rex

Abstract

The potential to invest sequentially in related assets creates a tradeoff between diversification and concentration. Loading a portfolio with correlated assets has the potential to inflate variance, but also creates information spillovers and real options that may augment total return and mitigate variance. We examine this tradeoff in the context of petroleum exploration. Using a simple model of geological dependence, we show that the value of learning options creates incentives for investors to plunge into dependence; i.e., to assemble portfolios of highly correlated exploration prospects. Risk-neutral and risk-averse investors are distinguished not by the plunging phenomenon, but by the threshold level of dependence that triggers such behavior. Aversion to risk does not imply aversion to dependence. Indeed the potential to plunge should be larger for risk-averse investors than for risk-neutral investors. We test the empirical validity of our theory by examining bidding activity in petroleum lease sales. We find significant plunging behavior across a broad sample of oil companies. We also find that privately-held firms pursue even more concentrated (less diversified) prospect portfolios than publicly-held firms--which we attribute to risk aversion rather than size.

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Bibliographic Info

Article provided by Elsevier in its journal The Quarterly Review of Economics and Finance.

Volume (Year): 49 (2009)
Issue (Month): 3 (August)
Pages: 1009-1033

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Handle: RePEc:eee:quaeco:v:49:y:2009:i:3:p:1009-1033

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Web page: http://www.elsevier.com/locate/inca/620167

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Keywords: Diversification Information spillovers Petroleum exploration Portfolio choice Learning options Risk aversion Entropy;

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Cited by:
  1. Martzoukos, Spiros H & Zacharias, Eleftherios, 2008. "Real Option Games with R&D and Learning Spillovers," MPRA Paper 12686, University Library of Munich, Germany.

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