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Rational Plunging and the Option Value of Sequential Investment The Case of Petroleum Exploration

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  • James L. Smith
  • Rex Thompson

Abstract

Any investor in assets that can be exploited sequentially faces 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. The task of optimal portfolio design is therefore to strike an appropriate balance between diversification and concentration. 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 explorationists 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 may be larger for risk-averse investors than for risk-neutral investors. To test the empirical validity of our theory, we examine the concentration of bids tendered in petroleum lease sales. We find that higher levels of risk aversion are associated with a revealed preference for more highly concentrated (i.e., less diversified) portfolios.

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Bibliographic Info

Paper provided by Massachusetts Institute of Technology, Center for Energy and Environmental Policy Research in its series Working Papers with number 0602.

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Date of creation: Feb 2006
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Handle: RePEc:mee:wpaper:0602

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  1. Paddock, James L & Siegel, Daniel R & Smith, James L, 1988. "Option Valuation of Claims on Real Assets: The Case of Offshore Petroleum Leases," The Quarterly Journal of Economics, MIT Press, vol. 103(3), pages 479-508, August.
  2. James L. Smith and Rex Thompson, 2008. "Managing a Portfolio of Real options: Sequential Exploration of Dependent Prospects," The Energy Journal, International Association for Energy Economics, vol. 0(Special I), pages 43-62.
  3. Lawrence M. Benveniste & Alexander Ljungqvist & William J. Wilhelm & Xiaoyun Yu, 2003. "Evidence of Information Spillovers in the Production of Investment Banking Services," Journal of Finance, American Finance Association, vol. 58(2), pages 577-608, 04.
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  6. Vishwanath, Tara, 1992. "Optimal Orderings for Parallel Project Selection," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 33(1), pages 79-89, February.
  7. Hendricks, Kenneth & Porter, Robert H, 1996. "The Timing and Incidence of Exploratory Drilling on Offshore Wildcat Tracts," American Economic Review, American Economic Association, vol. 86(3), pages 388-407, June.
  8. Walter J. Mead & Asbjorn Moseidjord & Philip E. Sorensen, 1983. "The Rate of Return Earned by Lessees under Cash Bonus Bidding for OCS Oil and Gas Leases," The Energy Journal, International Association for Energy Economics, vol. 0(Number 4), pages 37-52.
  9. Saha, Atanu, 1997. "Risk Preference Estimation in the Nonlinear Mean Standard Deviation Approach," Economic Inquiry, Western Economic Association International, vol. 35(4), pages 770-82, October.
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  11. Kenneth Hendricks & Dan Kovenock, 1989. "Asymmetric Information, Information Externalities, and Efficiency: The Case of Oil Exploration," RAND Journal of Economics, The RAND Corporation, vol. 20(2), pages 164-182, Summer.
  12. Glenn Ellison & Edward L. Glaeser & William Kerr, 2007. "What Causes Industry Agglomeration? Evidence from Coagglomeration Patterns," NBER Working Papers 13068, National Bureau of Economic Research, Inc.
  13. Vishwanath, Tara, 1988. "Parallel Search and Information Gathering," American Economic Review, American Economic Association, vol. 78(2), pages 110-16, May.
  14. M. L. Weitzman & K. Roberts, 1979. "Funding Criteria for Research, Development and Exploration Projects," Working papers 234, Massachusetts Institute of Technology (MIT), Department of Economics.
  15. Bo, Hong & Sterken, Elmer, 2007. "Attitude towards risk, uncertainty, and fixed investment," The North American Journal of Economics and Finance, Elsevier, vol. 18(1), pages 59-75, February.
  16. Marcello Span´┐Ż, 2007. "Managerial Ownership and Corporate Hedging," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 34(7-8), pages 1245-1280.
  17. Childs, Paul D. & Ott, Steven H. & Triantis, Alexander J., 1998. "Capital Budgeting for Interrelated Projects: A Real Options Approach," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 33(03), pages 305-334, September.
  18. Tufano, Peter, 1996. " Who Manages Risk? An Empirical Examination of Risk Management Practices in the Gold Mining Industry," Journal of Finance, American Finance Association, vol. 51(4), pages 1097-1137, September.
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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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