Option value and investment timing: an empirical application to natural gas in Alberta

Abstract

This thesis applies a real options approach to the valuation of undeveloped natural gas reserves in Alberta. The real options approach is recommended as an alternative to standard net present value analysis in situations where the investment is irreversible, future cash flows are uncertain, and the firm has operating flexibility to delay investment. Cash flow uncertainty is mcxlelled solely as a function of natural gas price volatility. Standard net present value analysis has several disadvantages in making risky investment decisions. Most prominent is its inability to evaluate the potential benefits from delaying an irreversible investment, thus resulting in non-optimal decision rules. This thesis attempts to econometrically test whether real options theory or discounted cash flow analysis is better able to explain investment behaviour from a statistical point of view.