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Managing a Portfolio of Real options: Sequential Exploration of Dependent Prospects

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  • James L. Smith and Rex Thompson

Abstract

We consider the impact of sequential investment and active management on the value of a portfolio of real options. The options are assumed to be interdependent, in that exercise of any one is assumed to produce, in addition to some intrinsic value based on an underlying asset, further information regarding the values of other options based on related assets. We couch the problem in terms of oil exploration, where a discrete number of related geological prospects are available for drilling, and managementÕs objective is to maximize the expected value of the combined exploration campaign. ManagementÕs task is complex because the expected value of the investment sequence depends on the order in which options are exercised. A basic conclusion is that, although dependence increases the variance of potential outcomes, it also increases the expected value of the embedded portfolio of options and magnifies the value of optimal management. Stochastic dynamic programming techniques may be used to establish the optimal sequence of investment. Given plausible restrictions on the information structure, however, we demonstrate that the optimal dynamic program can be identified and implemented by policies that are relatively simple to execute. In other words, we provide sufficient conditions for the optimality of intuitive decision rules, like Òbiggest first,Ó Òmost likely first,Ó or Ògreatest intrinsic value first.Ó We also develop exact analytic expressions for the implied value of the portfolio, which permits the value of active management to be assessed directly.

Suggested Citation

  • 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.
  • Handle: RePEc:aen:journl:cw-sped-a04
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    Cited by:

    1. Martinelli, Gabriele & Eidsvik, Jo & Hauge, Ragnar, 2013. "Dynamic decision making for graphical models applied to oil exploration," European Journal of Operational Research, Elsevier, vol. 230(3), pages 688-702.
    2. Smith, James L. & Thompson, Rex, 2009. "Rational plunging and the option value of sequential investment: The case of petroleum exploration," The Quarterly Review of Economics and Finance, Elsevier, vol. 49(3), pages 1009-1033, August.

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    JEL classification:

    • F0 - International Economics - - General

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