U N I V E R S I T P A R I S 1 P A N T H O N S O R B O N N E

Thesis


AnalysisofOptionsinFPSOLeasingContracts

RDIGPAR:
GWENCHLANCATHERINE
DIRECTEURDUMMOIRE:
OLIVIERBRANDOUY

I N S T I T U T D A D M I N I S T R A T I O N D E S E N T R E P R I S E S D E P A R I S
International Master in Business Administration MBA
Promotion 2010 - 2011
2

lUniversitnentenddonneraucuneapprobationniimproba
tionauxopinionsmisesdanscemmoire:cesopinionsdoi
venttreconsidrscommepropresleurauteur.

3
Acknowledgement
To Olivier Brandouy for his lively and exciting corporate finance classes which gave me the
desiretodiscovermoreontheconceptofRealOptions,foracceptingtosupervisethisthesis
and over all for his invitation to attend the Master 2 Decision Sciences and Risk Manage
mentatENSAMParisandIAEParis.

ToDamienMoureyforhisinspiringmanagementaccountingclasses,hisindepthanalysisof
managerialissueswhichalwaysraisedmyinterestanddevelopedmycuriosity,andlastbut
notleastforhisparamountcontributionasDirectoroftheMBAtoalwaysdeliverahighlevel
education.

To Delphine Dion for her valuable inputs on the importance of methodological aspects in
researchandspecificallyforthisthesis.

To Elizabeth Minik for her kind support to all students of the MBA and her always positive
attitudeand

ToAdelineLeclercqforhergreathelpandexpertiseinmodelingstochasticphenomena.
4
TableofContents
1 Introduction.........................................................................................................................6
2 OilFieldDevelopmentwithLeasedFPSO............................................................................7
2.1 BasicsofOffshoreOilProduction................................................................................7
2.2 TechnicalAdvantagesofFPSOforfielddevelopment..............................................11
2.3 OilCompaniesdilemma:LeaseorOwn.....................................................................12
2.4 FPSOleasingcontracts...............................................................................................12
2.5 EconomicsofFPSOleasingcontracts........................................................................14
2.6 UncertaintiesandRisks.............................................................................................16
3 OptionsinFPSOleasingcontracts.....................................................................................18
3.1 Optionstoextend......................................................................................................19
3.2 OptionstoPurchase..................................................................................................22
3.3 ActualExerciseofOptionsbyOilCompanies............................................................23
3.4 BeyondContractualOptions.....................................................................................24
4 ValuationofOptionstoExtend.........................................................................................25
4.1 AmovetowardvalueforFPSOContractors..............................................................25
4.2 LiteratureReview.......................................................................................................26
4.3 ExploringSimplecases...............................................................................................27
4.4 AfirstattempttovalueOptionstoextend...............................................................33
5 ManagerialComments......................................................................................................40
6 Conclusion.........................................................................................................................42

5
ExecutiveSummary
Floating Production Storage and Offloading platform (FPSO) is the preferred if not the only
solution toextractcrude oil from offshore oil fields indeepwaters.The possibilityto move
FPSOs from one field to another in addition to great operating flexibility makes possible to
have FPSO owned by specialized Contractors and leased to Oil Companies. To cater for the
uncertainneedsofOilCompanies,theleasingcontractsaregenerallybuiltwithafirmperiod
plus several options to extend the lease. In addition, options to purchase the FPSO are of
feredtoOilCompanies.
Themainuncertaintiesassociatedwithproducingoilfields,highlyvolatileoilpricesandun
certain underground oil reserves, give those options a real value. In case of high oil prices,
theOilCompanywillfindinterestingtocontinueproducingthefieldevenifatasmallerrate
reachingtheendofthefieldlife.Ontheopposite,theoptionswillnotbeexercisedincaseof
low prices. Similarly, if the field prove to contain more oil than initially anticipated, the op
tionstoextendtheleasingcontractwillseetheirvalueincreasing.
WehavecollectedactualdataonFPSOleasingcontractsawardedsince2000.Itgivesinter
estinginsightsonOilCompaniesbehaviorswithregardtothebalancebetweenfirmperiod
and optional period. Clear risk aversion can been observed as options are massively exer
cised.
DespitethesignificantpotentialvalueofoptionsforOilCompanies,thetraditionalapproach
usedbyFPSOContractorsforpricingleasingcontractsreliesonDiscountedCashFlowanaly
sis.Withinthiscostdrivenframeworknovalueisattributedtotheoptionsoffered.Propos
ing a valueoriented approach we believe using a proper valuation of the options encom
passingthepriceandreserveuncertaintiescanleadtonewcompetitivepricingstrategiesfor
FPSO leasing contract. A simplified mathematical model is developed as a first attempt to
valueoptionstoextendandappliedonacasestudy.

1 INTRODUCTION
In a highly capitalistic business such as offshore oil production, leasing assets is a seductive
alternative for financing new projects. Whereas aviation firms rent planes and construction
firms rent machinery through leasing contracts, the production assets on offshore oil fields
aregenerallynotavailableforrentonanymarketastheyaremostofthetimebuiltonpur
posetofieldspecifictechnicalrequirements.OilCompanieshavethereforetofundupfront
all investments needed to bring a field to production, almost 500 Billion United States Dol
lars (USD) in 2008. There is however one exception: Floating production, storage and of
floading platforms (FPSO) can be leased by Oil Companies from specialized Contractors
which operate them. The main reason for this exception lies in the fact that FPSO can be
movedfromonefieldtoanotherwithgenerallymoderatemobilizationandadaptationcosts
inrelativeterms.

Leasing contracts can be either pure financial lease or operating lease. In the latter case,
Contractors support most of the asset risks and the production phase options are normally
offeredtotheOilCompaniestoextendthecontractorpurchasetheFPSO.Despitethelarge
amounts at stakes, up to more than one billion USD, FPSO Contractors on the Discounted
CashFlow(DCF)methodforpricingofFPSOleasingcontracts.Althoughwellacceptedinthe
businesssphereitislargelycriticizedforitsintrinsiclimitations.TheinabilityofContractors
to capture the value of options included in FPSO lease contracts with the DCF approach is
believedtoleadtoundervaluedprices.

The economic significance of FPSO leasing stresses the need for the development of sound
and robust valuation models to assists managers of FPSO Contractors. To our knowledge,
there are no previous studies in the business or the academic literature which analyze the
problemofoptionsvaluationinFPSOleasecontracts.Theexistingliteraturedealingwiththe
valuation of asset leasing contracts studies markets such as real estate or transportation
vehicles (Grenadier 94) where competitive equilibrium can be realistically assumed leading
toanendogenousdeterminationoftheassetvalueprocess.Alternatively,JorgensenandDe
Giovanni (2010) use an exogenous spot price mean reverting model for ship leasing con
tractsand derivethevalueof embeddedoptions. However,both approachesareirrelevant
forFPSOsasFPSOsarenotsubstitutesforeachother,onecannotsubstituteeasilyaFPSOby
another on a specific field, and no liquid market does exist for short term rent, a pre
requisite for the existence of a competitive equilibrium. A new approach is therefore re
quired.
We propose here a value oriented approach linking the options values with the potential
profits of the Oil Companies. Recognizing the central role played by uncertainties in future
7
oil prices and in the quantity of underground oil reserves, we propose to value options to
extendaFPSOleasingcontractconsideringtheflexibilityofferedtoOilCompaniestoadapt
against positive or negative evolutions of those two main uncertainties. The difficulties are
many.First,Contractorshavenormallyverylimitedinformationonthefieldreservesatthe
timeofbiddingforanewcontract.Theproposedmethodologyshouldthereforenotbetoo
sensitive on the production model used. Second, leasing contracts can last more than 10
years. Future oil prices have therefore to be estimated using a stochastic model as no fu
tures contract with time horizon greater than 2020 are available on the NYMEX or other
commodity derivatives trading markets. Lastly, a realistic decision making model shall be
consideredfortheexerciseofoptions.Inotherworks,exerciseoftheoptionshallbebased
ontheexpectationsoffutureprofitfortheOilCompanyconditionaltothesimulatedvalues
of oil pricesand oil productionuntilthetime ofthedecision.Inafirst attemptto valueex
tension options, we use a Monte Carlo method and stochastic processes for oil prices and
production profiles. The decision making process is based on a simplified approach. Ulti
mately, thevalue ofoptions are calculatedrecursively from thediscountedvaluesof lease
contractswithdifferentfirmperiodsaveragedoverallthesimulatedcases.

TheSection2explainsthecontextofoffshoreproductionwithleasedFPSOs.Itprovidesthe
essentialtechnicalandeconomicbackgroundrequiredforunderstandingtheissuesatstake
in FPSO leasing contracts and the associated options. The Section 3 analyses the two com
montypesofoptions:extensionoptionsandpurchaseoptions.Itexplorestheactualuseof
optionsbyOilCompaniesandtriestoderiveusefulconclusionsforContractors.TheSection
4detailstheproposalforanewpricingapproachbasedonvaluationofoptionsfromtheOil
Companies perspective. It reviews the literature existing on the valuation on asset leasing
contracts,makesafirstattempttovalueoptionsusingsimplifieddecisionrulesfortheexer
cise of options and applies the proposed method to a case study. The Section 5 proposes
commentsfromamanagementperspectiveontheresultsofthepresentworkanditspoten
tialuseinfuturebusinessopportunities.

2 OILFIELDDEVELOPMENTWITHLEASEDFPSO
Historically, oil has been produced offshore since the end of the 1940s. At this time, all oil
production platforms were directly supported on the seabed. Later, as new oil fields were
being discovered in deeper waters, floating production platforms were needed to produce
those fields. Eventually, the first oil Floating Production Storage and Offloading unit (FPSO)
wastheShellCastellon,builtinSpainin1977.

2.1 BASICSOFOFFSHOREOILPRODUCTION
8
2.1.1 FROMDISCOVERYTOPRODUCTION
Fromthediscoveryofapotentialoilfield,thewayislongtobeabletoextracttheenclosed
oilandgas.First,anOilCompanydrillsawellinapromisinglocation.Onceoilisfound,the
assessmentphasestarts.Thequantityandthequalityofoilandgasareestimated.Facilities
for producing the oil and gas are designed. Then other wells are drilled and all production
facilities are built. Afterthisstage, the oil production starts. The oil flows naturally through
thewellsandreachesthesurfacewhereitistreated.Thisproductionphaselastsaslongas
oilandgasarerecoveredataprofitablerate.

The largest oil fields can be spread over several hundreds of kilometers. For those giant
fields,theproductionphasecanlastmorethan20years.Morecommonly,oilfieldsproduc
tiondurationrangesfromseveralyearsto20years.

Forfieldslocatedoffshore,thereareseveralpossibletypesofproductionfacilities,common
lyknownasoffshoreplatforms.Goingfurtherintothedetails,onecandistinguishthefixed
facilitieswhicharesupportedonthegroundforwaterdepthupto150metersandthefloat
ing facilities which can be moored in almost any water depth. Among them, the FPSO are
consideredasthe mostflexiblesolutions toproduce offshore oil fields.Formoredetails on
FPSO,valuableinformationcanbefoundinLuciaLombardo(2003).

GRAPH1MAINTYPESOFOFFSHOREPLATFORMS(SOURCEHTTP://OILRIGDRILLINGS.COM)

2.1.2 ECONOMICSOFOILPRODUCTION
ExplorationandProductionofoilisaverycapitalintensivebusiness.TheOilCompanieshave
to invest large amounts of capital at eachstep of the fielddevelopment. In return of those
largeinvestments,theOilCompaniesexpectawealthyincomeduringtheproductionphase.
9
Theincomegeneratedfromthesaleonthemarketoftheproducedcrudeoilhasindeedto
compensateforallpreviousinvestmentsandtodeliversoundprofits.

Thecostsofbringingtoproductionandproducinganoilfieldcanbesplitin3maincatego
ries
Exploration expenses: Purchase of a license for exploration and production,
purchaseofSeismicsurveys,Drillingofexplorationwells.
Development expenses: Management and Engineering of field development,
Drilling of production wells, Design, construction and installation of subsea infra
structures,subseatosurfacelinks,andFPSO(ifnotleased)
Operatingexpenditures:personnel,maintenance,consumables,services

When taking an Investment decision, an Oil Company makes a thorough assessment of the
expensesandincomesanticipatedforthedevelopmentofanoilfield.Acommonpracticeis
to build a model of Discounted Cash Flows (DCF) and to consider criteria such as Internal
Rate of Return (IRR), payback period and Net Present Value (NPV) for taking decision. Alt
hough such approach has many limitations, payback of 5 years maximum and IRR of 15%
minimumarebroadlyconsideredasminimumthresholdsfornewinvestments.

MainUncertainties
OneofthemostrecognizedflawoftheDCFmodelistoconsidertheinputparametersofthe
model as fixed and certain. This seems to be in contradiction to the volatile nature of oil
prices on commodities markets and to the uncertain nature of underground sciences. As a
matteroffact,fielddevelopmentprojectsfaceseveralsourcesofuncertainties:
Costandtimescheduleofbuildingtheinfrastructuresandfacilities
Volumeofoilthatcanberecovered
Priceofoilduringtheproductionphase
Operatingcostsinflationduetotechnicalorexogenousfactors

Theendofeasyoil?
For about one century, oil is being produced in various parts in the world. Oil Companies
haveproducedfirstthefieldswiththeleastcomplexity,resultinginlowerproductioncosts.
The always increasing demand of oil has led Oil Companies toward more technically chal
lengingfieldssincethemidoftheeighties.Morerecently,somecountriessuchasVenezuela
forexamplehavelimitedtherighttoproduceoilintheirterritorytonationalcompanies.As
a consequence, Oil Companies have no other choice than to produce oil fields with higher
productioncostperbarrelsuchasoffshorefields,orfieldslocatedinarcticareas.
10
Anothercharacteristicofthelast8yearsisthedramaticincreaseofoilpricevolatility.After
twentyyearsofstabilityduringtheeightiesandthenineties,oilpricesreachedrecordlevel
in 2007 followed by a vertiginous fall in 2008. Since then, oil prices are back to historically
highlevels.

GRAPH2BRENTINDEXFORCRUDEOIL(SOURCE:DATAFROMICE)

Thegraph2illustratesthevariationofBrentindexrepresentingthepriceofabarrelofcrude
oilnegotiatedinNorthernEuropefortheperiodbetween1987and2011.Thehighvolatility
makesdifficulttoforecastfutureoilprices.

Atthesametime,thecostsofbuildingfieldproductionfacilitieshaveshowedsimilartrends.
The volatility has increased even if it remains at a lower level. Graph 3 shows the variation
fromyear2000untilendof2011ofthecostindexesforthemainelementsinvolvedinthe
developmentofoffshorefields.Thedirectconsequenceisthedifficultytoestimatecorrectly
thecostoffielddevelopment.

GRAPH3COSTINDEXESFOROFFSHOREINDUSTRYSEGMENTS(SOURCE:IHSCERA)
11

This new environment has direct impact on the methodology used so far to evaluate the
economicsofdevelopinganewfield.Farfromapredictablefuture,OilCompaniesarenow
facingmoreuncertaintywithtechnicallychallengingfieldsdespitetechnologyimprovement
inreservoirengineering.Consideringalsothelimitedvisibilityonfutureoilprices,DCFanaly
sisstraightforwardresultsmaynotbeasclearcutas15yearsago.

2.2 TECHNICALADVANTAGESOFFPSOFORFIELDDEVELOPMENT
TheuseofFPSOforoilfielddevelopmenthasseveraladvantagescomparedtoothertypesof
production facilities such as fixed platforms, subseaprocessing or other floating facilities
(semisubmersibleplatforms,SPAR,etc).ThemainpeculiaritiesofFPSOsare:
Mooring:Itcanbeinstalledinanywaterdepthfrom20to2,500meters
Crude oil storage: the hull of the FPSO include large tanks where crude oil is stored
until andoffloading operationtoanother tanker.Thisrenders thedevelopment of a
remote field much easier as it is almost a standalone unit. And exporting crude oil
doesnotrequiresubseapipelinesandonshoreportfacilities.
Large area and payload for oil processing facilities. The large vessel main deck area
offersmorespacethanonotherplatforms.ForanOilCompany,thismeansincreased
flexibility.Initiallynotalldeckspacemaybeneededfortheprocessingmodules.Lat
erontheunusedspacecanbeusedtoaddnewequipmentormodules.Modification
oftheFPSOduringtheproductionmaythereforeallowtoincreasetheproductionof
theoilfieldortoconnectanotherfieldlocatednearby.
Relocation. Once the production of a field is completed, the FPSO may be easily
moved to another field. This operation is called a redeployment as normally some
modifications on the FPSO are required to cope with the new field peculiarities. On
thecontrary,fixedplatformsmayonlybetransferredtoanewlocationataveryhigh
costwhichrendersthisoperationnoteconomicallyviable.

Overall,thosefourmainfeaturescreatenumerousopportunitiesforoffshorefielddevelop
ment.OneofthemainconsequencesisthataFPSOisnotirrevocablyassociatedtoafieldas
a fixed platform is. The existence of a potential second life beyond the production of the
specific field for which it has been designed gives an FPSO its own economic life inde
pendentlyfromthefieldfixedassets(wells,subseapipelines,etc).Hence,theFPSOowner
ship is not mandatorily with the Oil Companies but can be with specialized Contractors
which provide FPSO as a service to Oil Companies. Such firms are commonly called FPSO
Contractors,alsonamedContractorhereafter.

12
2.3 OILCOMPANIESDILEMMA:LEASEOROWN
At the initial stage of a field development involving a FPSO, an Oil Company has to make a
choicewhethertoowntheFPSOortoleaseitfromaFPSOContractor.
In the first case, the Oil Company awards a contract for the Engineering, Procurement and
Construction ofafitforpurpose FPSO, commonly called anEPC Contract. Upondeliveryby
theEPCContractoroftheFPSO,theOilCompanyhasitsownpersonneloperatingtheFPSO
forthewholeproductionphaseuntilthedecommissioning.
In the second case, the Oil Company awards a contract to a FPSO Contractor for leasing a
FPSO. The FPSO can be either designed specifically for the field or be an already existing
FPSO which could be adapted to suit this particular field. The FPSO is then operated and
maintained by the FPSO Contractor's employees. A the end of the leasing contract, the Oil
CompanyhasnoliabilityorresponsibilityfordecommissioningtheFPSO.

The FPSO lease/own dilemma can be seen as a variant of the classical case of asset leasing
treatedbyMyers,DillandBautista(1976).InsteadofpayingaleasingratetotheFPSOCon
tractor,theOilCompanycanborrowanamountofmoneyequivalenttothecostoftheFPSO
and buy one. There are however other considerations that affect the choice of Oil Compa
nies:
Riskmanagement:thecostofaonedayproductionstopduetoanybreakdowncan
bevery high on FPSO with largeproductioncapacity.The Oil Companyisin abetter
positiontomanagethisriskthroughefficientmaintenance.Ontheopposite,aFPSO
Contractormaywanttolimitthemaintenanceexpendituresasitonlyriskslosingthe
dayrate.
Ability to borrow: except a few Majors, Oil Companies may find difficult to fund the
entire field development which could represent more than one billion USD for a
deepwateroffshorefield.LeasingtheFPSOmaythenbetheonlychoice.
Lack of technical capabilities: Not all Oil Companies have inhouse the technical ca
pabilitiestofullymanageaFPSOasdiscussedinmoredetailsinchapter2.4.

Asamatteroffact,leasingFPSOprovestobeverypopularwithinOilCompaniesandonlya
handfulofthemdirectlyownsandmanagesFPSOs.

2.4 FPSOLEASINGCONTRACTS
TypicallyaFPSOleasingcontractiscomposedasfollows.TheFPSOContractorengageshim
selfwithmakingavailabletotheOilCompanyanFPSO.TheFPSOshallmeetsomeminimum
technicalspecificationsrequiredbytheOilCompany.Itshallbefitforitsintendedpurpose:
13
producingaparticularoilfield.Anditshallbemaintainedingoodconditionsthroughoutthe
durationofthecontract.TheOilCompanycompensatestheFPSOContractorfortheservices
providedbywayofafixeddailyratefortherentaloftheFPSO(thebareboatrate)andadai
lyratefortheoperationsoftheFPSO.Theoperationratecanbesubjecttoarevisionformu
latoaccountforcostsinflationduringthecontract.Theothermaincomponentofaleasing
contractisitsduration.Generally,theleasingcontractismadeofafirmdurationandpossi
bilities to extend through options. For example, a contract could have a firm duration of 7
years and include 5 options to extend the leasing contract by one year each. So the mini
mumdurationofthecontractis7yearsandthemaximumis12years.ShouldtheOilCom
panywanttocontinueproducingthefieldwiththeFPSObeyondthemaximumduration,the
contract would not apply. In such case, the Oil Company would have to negotiate with the
Contractoranewleasingcontract,thetermofwhichcouldbequitedifferentfromthepre
viouscontract.

OptionsofferedtotheOilCompanies
AlthoughtheOilCompanydoesnotowntheFPSOinaleasingcontract,itisinclinedtoretain
sufficientflexibilityinthecontracttoadapttotheactualneedsoftheoilfieldproduction.Oil
Companiesthereforegenerallyrequesttohave2typesofoptionsincludedinthecontract:
Optionstoextendthedurationofthecontract,
OptionstopurchasetheFPSO.
At thetimeof thecontractsignature,the priceof those optionsare known andincluded in
the contract schedule of price. During the execution of the contract, the Oil Company has
the choice to exercise the options or not. For example, consider a leasing contract with a
firmdurationof10yearsandabareboatrateof150,000USDperday.Thisleasingcontract
alsoincludesoneoptiontopurchasetheFPSOfor350MillionUSDafter5years,oneoption
topurchasetheFPSOfor150MillionUSDafter10years,and5optionstoextendtheleasing
contractbyoneyearwithaspecificbareboatrateof100,000USDperday.

OtheradvantagesforOilCompanies
LeasinganFPSOinsteadofowningitcanprovidealsoseveraladvantagestoanOilCompany.
Incasetheoilfielddoesnotperformasexpected,theliabilityoftheOilCompanyis
limitedtotheamountsdueaccordingtotheleasingcontract.Hence,theOilCompa
nysrisklevelismuchlowerthanifithastoconsiderthefullcostoftheFPSOinvest
ment.
ThecapitalinvestmentrequiredfortheFPSOdesignandtheconstructionismadeby
theOilContractorandnottheOilCompany.TheFPSOisthereforeoffbalancesheet
fortheOilCompany.ThisisparticularlyimportantforsmallindependentOilCompa
nieswhichdonothavelargefundsavailable.
14
The technical management of the FPSO remains under the responsibility of special
izedFPSOContractor.ExcepttheInternationalMajors(Chevron,Shell,BP,TOTAL,)
mostofthesmalleroilCompaniesdonothaveasufficientpooloftechnical person
nel with the required skillset to operate and maintain efficiently an FPSO. Instead
FPSOContractorsmanagingalargefleetofFPSOsbenefitfromeconomyofscale,re
turn of experience and continuous improvement processes using expertise and les
sonslearntfromtheoperationstoimprovedesignofnewFPSOs.

2.5 ECONOMICSOFFPSOLEASINGCONTRACTS
For FPSO Contractors, the economic equation is quite simple. After a competitive bid, the
winning Contractor designs and builds a FPSO to be leased for a minimum duration corre
spondingtothefirmduration.TheexpensesoftheFPSOContractorsareoftwotypes:pay
mentoftheinitialinvestmentandtheassociatedfinancialcosts(CAPEX),andtheoperating
expenditures (OPEX). The income of the FPSO Contractors comes from the payment by the
OilCompaniesofdayrates.SuchpaymentisinfactsubjecttotheavailabilityoftheFPSOon
siteforproduction.

The economicequationwould betrivialshould theeconomicand technical lifeoftheasset

bethesameasthefirmdurationoftheleasingcontract.Attheendoftheleasingcontract,
theassetwouldbefullydepreciatedwithnofurthereconomicvalueandwouldbescrapped
immediatelyafterthecontractend.Thisisthecaseinafinanciallease.
Foroperatingleases,thefirmperiodisshorterthantheassetdesignlife.Asaminimum,the
designlifeshouldbeequaltothesumofthefirmdurationplusalltheoptionstoextend.The
remaining economic value of the FPSO will therefore never be null at the end of the firm
period.TheFPSOContractorthereforefacesadilemma.Shouldaprudentapproachbeused
andtheassetdisposalvalueattheendofthefirmperiodbeconsideredasnull?Orshould
thedisposalvaluebeinlinewithitsdesignlife?Choosingthelatersolutionmeansaccepting
the risk of having the leasing contract terminated at the end of the firm period and facing
difficulties to materialize the disposal value considered originally. Such choice depends on
theFPSOContractormanagementpolicyandriskaversion.

Forpricingbothoperatingorfinancialleasewhenbiddingforanewcontract,FPSOContrac
torsusetraditionallyaDCFmodel.ThecashinflowsarethepaymentsofdayratesbytheOil
CompanyandthesaleoftheFPSOattheendoftheleasingcontractforanestimatedresid
ualvalue.ThecashoutflowistheinitialinvestmentintheFPSOdesignandconstruction.The
15
FPSO Contractors managementfixthe targetlevelofInternal RateofReturn(IRR)the new
contractshouldachieve.Thenthedayrateiscalculatedtoreachthetarget.
Inordertoillustratethemethod,thebestistotakethesimplifiedexampleofa8yearfirm
leasing contract. The design and construction of the FPSO represent an investment of 1.2
BillionUSD.Thedayrateis530kUSD.Theresidualvalueoftheassetafter8yearsisestimat
edat30%oftheinitialinvestment,ie360MUSD.TheDCFmodelisthenstraightforwardand
thecalculatedInternalRateofReturn(IRR)is10%asdetailedinTable1.Althoughtaxissues
should normally be included in the DCF model, taxes are not considered here for sake of
simplicity.

TABLE1EXAMPLEOFLEASERATEDCFCALCULATION

Provided everything goes as planned, the leasing contract provides an IRR of 10% after 8
years.Then,consideringaWeightedAverageCostofCapital(WACC)of8%asthediscount
ingrate,thenetpresentvalue(NPV)calculatedafter8yearsis106MUSDasrepresentedin
Graph4.

GRAPH4NETPRESENTVALUEFORA8YEARFIRMCONTRACT(SOURCE:THEAUTHOR)
CAPEX(k$) 1200000 Residualvalueafter8years 30%
Dayrate(k$/day) 530 commercialuptime 100%
DiscountingRate 10,0%
Year 0 1 2 3 4 5 6 7 8
Cashin 193450 193450 193450 193450 193450 193450 193450 193450
Cashout 1200000
ResidualValue 360000
CashFlows 1200000 193450 193450 193450 193450 193450 193450 193450 553450
CumulativeCashFlows 1200000 1006550 813100 619650 426200 232750 39300 154150 707600
discountingfactor 1,00 0,91 0,83 0,75 0,68 0,62 0,56 0,51 0,47
PV 1200000 175864 159876 145342 132129 120117 109197 99270 258189
NPV 1200000 1024136 864260 718918 586790 466672 357475 258204 16
16

2.6 UNCERTAINTIESANDRISKS
Productionactivitiesintheoilbusinessarebynaturesubjecttolargeuncertaintiesandsig
nificant risks. Through contractual provisions in the lease contracts, technical and commer
cialunderlyingrisksaresplitbetweentheContractorandtheOilCompany.Whilebothpar
tiesfacerisksofvariousorigins,thepresentchapterpresentsonlytheriskshavingsignificant
directimpactontheeconomicresultsofthebothparties.

2.6.1 RISKSBORNBYFPSOCONTRACTOR
CostoverrunduringFPSOengineeringandconstruction
OncetheleasingcontractissignedwiththeOilCompany,themaximumincomeoftheFPSO
Contractor is fixed. But the expenses to be incurred as part of the investment in the FPSO
construction are only estimated. The actual cost could prove to be higher than the initial
estimate.Thedirectimpactisalowerthanexpectedfinancialresults.

ScheduleslippageduringFPSOengineeringandconstruction
Schedule risk has some similarity with the risk of cost overrun. Both schedule and cost are
estimatedpriortotheawardofaleasecontract.Asamatteroffact,theactualdurationand
cost of the engineering and construction phases can be greater than original estimates. In
theoryactualdurationandcostcanalsobesmallerthaninitialestimates,butitisrarelythe
case.Bothriskstakeplaceintheearlyphaseoftheprojectandhavedirectimpactonproject
NPV. A cost overrun corresponds to an increase of the initial investment. With income re
mainingthesame,itleadstoadecreaseoftheprojectNPV.Theimpactofdelaycanalsobe
understood as a cost impact. A delay in the FPSO completion implies a delayedstart of the
lease period and additional financial costs. Considering the example of 2.5, one year delay
leadstoanincreaseoffinancialcostsby96MillionUSD.

FPSOavailabilityrisk:commercialuptime
BycontracttheFPSOContractorispaidthefullrateonlyiftheFPSOisfullyavailableforpro
duction. In case of breakdown diminishing oil production, the day rate is not paid or only
partially. This scheme works as an incentive for FPSO Contractor to maintain the FPSO in
goodconditionsduringtheleasecontract.DuringtheFPSOearlylife,designorconstruction
issues may still needtobe fixed.The impactonNPVisevengreaterasitaffectscashflows
discounted with factors close to 1. The Graph 6 represents the NPV of the same lease con
tractasin2.5witha95%uptimeonlythroughouttheleaseperiod.
17

GRAPH5NETPRESENTVALUEWITHLOWERCOMMERCIALUPTIME

Disposalvalue:Scrap/redeploymentvalue
Theshortertheleasingcontractdurationisthemoreresidualvaluenormallyremainsatthe
endofthecontract.Thisvalueisestimatedpriortoenteringintotheleasingcontract.When
comestheendofthecontract,ithasstilltobematerializedeitherthroughasaleoftheunit
or through a new contract. This may not always be an easy task. The example of the FPSO
Falcon(sourceSBMreportsfrom20092011)clearlyillustratesthis.Itwaslaidupformore
than 3 years waiting for a new contract. The Graph 5 represents the impact on NPV of an
actualresidualvaluelowerthantheoneinitiallyestimated.

GRAPH6NETPRESENTVALUEWITHOVERESTIMATEDRESIDUALVALUE(SOURCE:THEAUTHOR)
18
2.6.2 RISKSBORNBYOILCOMPANIES
Technicaluncertainties:reservoir,recoveryrate,fieldlife
The quality of oil field is by nature difficult to predict. The geology of the reservoir and its
geometry are complex. Various physical and chemical parameters may affect the perfor
manceofanoilwell.AnOilCompanytriestoassesshowmuchoilawellwillproducebased
on the Seismic surveys and test wells drilled during the exploration phase. Some oil fields
were believed very promising but failed to deliver, for example the Golfinho field in Brazil.
On the contrary, some fields demonstrated much better production than expected prior to
the start of production. This technical uncertainty of the reservoir performance is perfectly
illustratedbytheexampleoftheJubileefieldoperatedbytheOilCompanyAnadarko.Prior
tothestartof production,4 differentproductionprofiles were consideredpossiblescenarii
byAnadarkoasshownonGraph7.

Commercialrisk=Oilpricevolatility
Beyond the quantity of oil recovered, the Oil Company supports the variations of the oil
priceduringtheprojectwholelife.Thedecisiontodevelopanoilfieldistakenknowingthe
oilpricehistory.ButtheincomeoftheOilCompanydependsonthefutureoilpricesduring
the whole production period. Considering as an example a field where production starts 3
yearsaftertheprojectsanction.Theexpectedfieldlifeis17years.Overall,theOilCompany
income is subject to market volatility for the next 20 years. This commercial uncertainty
shouldbeseenbothasariskandanopportunity.Consideringthesameoilfield,investment
decision had been taken on an average price of crude oil of 40 USD per barrel. But 5 years
after,oilpricereach100USDperbarrel.ThisresultsinmuchhigherprofitsfortheOilCom
pany.
Environmentalrisk:oilpollution
Oilpollutionisinherenttotheproductionactivities.Breakdownsoncriticalpartofthefacili
ties could lead to oil spillage. Even though most incidents remain limited in magnitude, a
large pollution is one of the most feared risk for Oil Companies. The most example is the
MacondoaccidentintheGulfofMexicoduringyear2010.Thefinesandvariouscompensa
tionsamountedtomorethan20billiontoBPanditsinsurers.

3 OPTIONSINFPSOLEASINGCONTRACTS
The previous section describes the fundamentals of developing an oil field with a leased
FPSO both from the Oil Company and the FPSO Contractor perspectives. As Oil Companies
face uncertain environment the options included in the leasing contracts offer interesting
tools for managing this uncertainty. This section first describes the most commonly used
options and analyses how they impact the Company and the Contractor. Then actual data
19
relatedtotheexerciseofoptionsbyOilCompaniesprovidesinterestingresultsonpotential
strategiesforFPSOContractors.

3.1 OPTIONSTOEXTEND
3.1.1 DESCRIPTIONOFTHEOPTIONS
MostoftheFPSOleasingcontractsincludeprovisionstoextendtheleasingoftheFPSObe
yond the fixed period set in the contract. The number and the duration of the options re
quested are given by the Oil Company as part of the tender documentation sent to FPSO
Contractors.
Should the Company exercise the option to extend, the Contractor will continue to make
availableforproductionitsFPSO.Duringtheoptiontoextend,theCompanywillpaytothe
Contractoradayrateunderthesamecontractualprovisions.Thedayratesassociatedwith
theoptionstoextendarepartoftheinitialcontract.ItmayhappenthataCompanyrequires
the day rate for the options to be the same as the one for the firm period. But quite often
differentdayratesarepossible.
Beyondtheoptionsofferedtoextendthelease,theCompanymaybeinterestedincontinu
ingtheproductionwithanFPSO.Insuchcase,theinitialleasecontractdoesnotapply.The
OilCompanyshallseekforanewagreementwiththeContractortocontinuethelease.Dif
ferenttermsandconditionsmayapply,reflectingthebalanceofpowersbetweenCompany
andContractoratthistime.

3.1.2 EXAMPLEOFTHEJUBILEEFPSO
Inordertoillustratetheconcept,thecaseoftheJubileeFPSOisagoodexample.Wewere
personallyinvolvedinthebiddingprocessfortheleaseofanewFPSO.Alldetailshereafter
come from the documentation provided at that time. The Company, Anadarko, requested
bidsforafirmperiodof7yearsandcompletedby13optionstoextendtheleasingperiodby
oneyear.OveralltheFPSOwasrequestedtohaveadesignlifeof20years.Initsinvitation
tobidders,Anadarkohadincludedthefollowingrequests
ExtensionofCharterTerm(Aftertheinitial7yearperiod).
Incaseofadditionalcharterperiods,CompanywillcompensateContractortheCharterRate
perDayof:
Charter Rate Schedule for Optional Exten-
sions
USD/Day
Extended charter period of 13 years
Year 8
Year 9
Year 10 (Etc.)
20

ExtensionofServicesafter20years.
CompanyretainstheoptiontohaveContractorextendtheBareboatCharterforadditional
periodsoftimebeyondtheinitialperiodoftheAgreementandalloftheextensionperiods
contemplated,subjecttomutualagreementbetweenCompanyandContractor.
Inthisexample,itisinterestingtonotethatdayratescanbedifferentforeachoneyearop
tion.ThisgivesopportunitytotheContractortoproposeacustomizedschemewithvarying
dayratesthatwouldbetterfitContractorneeds.Anothercommentistohighlighttherather
short firm period compared to the potential total leasing period: 7 years over a total of 20
years.ThisillustrateswelltheideaofOilCompaniesaimingtoreducetheirriskwithshorter
firmperiodandahighnumberofoptionstoextendtheduration.

WhileFPSOContractorswererequestedforbuildinga20yeardesignlifeFPSOintheframe
ofafirmleasingcontractofonly7yearsplusoptions,notechnicalinformationwasprovided
with regard to potential production profiles. Several production scenarios were considered
by the Company as illustrated in Graph 7 but this information was not disclosed to FPSO
Contractors.
The 4 scenarios account for different reservoir behaviors and the estimated quantity of re
coverable oil range from 362 Millions of barrels (mmbbl) in case n1 to 593 mmbbl in case
n4.AssumingtheFPSOturndownpoint(thepointatwhichproductionisnomoreprofita
ble and FPSO is demobilized) corresponds to 30% of the FPSO nominal capacity or 40,000
barrelsperday,thismilestoneisreachedafter7yearsonlyincasen1,thepessimisticsce
nario.Inthe3otherscenarios,thispointisreachedafter10yearsor15years.TheOilCom
pany choose the most pessimistic scenario to determine the firm leasing period. The firm
period is equal to the most pessimistic time to turndown and not to the expected time to
turndown.ThisisaclearpatternofriskaversionfromtheCompany.

21

GRAPH7JUBILEEFPSOPRODUCTIONPROFILESSCENARIOS(SOURCE:ANADARKO)

3.1.3 IMPACTOFOPTIONEXERCISEONFPSOCONTRACTORECONOMICS
Until now, the NPV were calculated only on the firm duration of the leasing contract. This
contract may however be extended by the Oil Company exercising the yearly options. In
suchcase,theNPVcanbeimprovedasillustratedinGraph8.Theredcurverepresentsthe
NPV ofa project having an IRR of 8% (same as the Contractor WACC) calculated on its firm
period and 3 options to extend by oneyear exercised by the Company. After 11 years, the
NPV is positive although the NPV was negative after the initial firm period. The exercise of
optionsbytheCompanyultimatelyincreasestheprojectNPVoftheContractor.

22

GRAPH8NETPRESENTVALUEWITHLOWERIRRANDCONTRACTEXTENSION(SOURCE:THEAUTHOR)

Atthesametime,theriskontheresidualvaluediminishes.Indeed,theFPSOresidualvalue
decreases with the time. A lower value has therefore to be considered after some more
years of operations on the field. The risk taken by the FPSO Contractor to monetize this
amountisdefactolower.ThiscanbeobservedgraphicallyonGraph8.ThepositiveNPVof
thebasecase(bluecurve)isonlyobtainedthroughthesaleoftheFPSOforitsresidualvalue
whichisdepictedinGraph8withaNPVstepbetweenyear7andyear8.Inthecaseofex
tendedlease,nosuchstepexists.

3.2 OPTIONSTOPURCHASE
In addition to the options to extend, Oil Companies normally request options to purchase
theFPSOinleasecontracts.ThisgivesasecondleveloffreedomforOilCompaniesinman
agingtheirfield.

An example of the contractual provisions associated with such options is given hereafter
fromtheJubileeFPSOcase:
Purchase of FPSO. At any time after achievement of Schedule Milestone M12B (Reference
ExhibitFContractSchedule)duringtheTermoftheAgreement,Companyretainstheop
tion to Purchase the FPSO. Such purchase would include all components provided under the
BareboatCharter,withconditionoftheFPSObeingthatinexistenceatthetimeoftheexer
ciseofthisoptionbyCompany.
23
In case of purchase of the FPSO by Company, Company will compensate Contractor on a
LumpSumbasissubjecttoagreedTermsandConditionsofthisAgreement,andthePurchase
Price given in the following Table, and no further Charter Rate payments shall be made by
Companyafterthedateofpurchase.

The analysis of historical data shows however such options are only rarely exercised by Oil
Companies. Among the 40 FPSO lease contracts considered in 3.3, only 3 FPSOs have been
purchasedafterthefirmperiodduration.
HavingsuchpurchaseoptionsishoweveramustforOilCompaniestoeasilytakeoverfroma
FPSO Contractor and continue producing the field after the purchase of the FPSO. Without
such option, the FPSO Contractor bankruptcy could put the Oil Company in a very difficult
positionandultimatelycausetostopoilproduction.

3.3 ACTUALEXERCISEOFOPTIONSBYOILCOMPANIES
Options being present in almost all contracts, we have gathered factual data on the actual
exerciseofthoseoptionsbyOilCompanies.TheaimisheretoderiveinformationonhowOil
Companies treat options from the analysis of actual recent data. Three types of sources
wereused:websitesofFPSOContractors,annualreportsandpresentationtoinvestors.The
dataset includes a total of 40 FPSOs owned and leased by the 3 leading FPSO Contractors:
SBM,ModecandBWO.Itrepresentsmorethan50%ofalltheFPSOscurrentlyleasedorwith
a signed leasing contract. Information on FPSO leased between 1980 and 2000 is not easily
available. This concerns however a very limited number of FPSOs. An extract of the data is
presentedinTable2forillustration.ThefulldatasetisavailableinAppendix2.

TABLE2EXTRACTOFFPSOLEASINGCONTRACTSDATASET(SOURCE:SBM,MODEC,BWO)

Thedatasetcontains17FPSOsforwhichthefixedleasingperiodisnowcompleted.Among
those17units,optionstoextendfor1yearormorewereexercisedbyOilCompaniesfor13
FPSOs,i.e.in76%ofthecases.Theaveragedurationoftheextensionis2.9years.Consider
N
FPSO
CONTRACTOR
FPSOName
Firm
Duration
(Year)
Optionsto
Extend
(Year)
Leasing
StartDate
LeasingEnd
Date
Options
exercised
(Year)
1 SBM Firenze 5,5 4 03/03/1998 30/04/2006 2,7
2 SBM Kuito 5 5 15/12/1999 01/12/2009 5,0
3 SBM Espadarte 8 5 03/07/2000 01/06/2013 4,9
4 SBM Brasil 5,5 4 07/12/2002 01/05/2012 3,9
5 SBM Xikomba 7 6 31/10/2003 01/06/2011 0,6
6 SBM MarlimSul 8 2 07/06/2004
7 SBM BarinovMOPUPetronas 3 2 08/03/2006 01/07/2009 0,3
8 SBM Capixaba 7 3 06/05/2006 01/04/2010
24
ingthetotaldurationoffixedperiodandextensionsoffersanotherperspective.Thesumof
thefixedperiodforthe17FPSOsamountsto80yearsandthetotaloftheextensionsrepre
sents50years.Sotheactualdurationoftheleasecontractsincreasedbyanaverageof60%
comparedtothefirmperiodincludedinthecontracts.

In order to complete this analysis, it is worth reviewing what happened to the 4 FPSOs
whose lease contract was not extended beyond the firm period. Three of them were pur
chased by the Oil Companies which exercised options to purchase included in thecontract.
Thelastone,XikombaFPSO,wasleasedinitiallytoExxonMobil.Shortlyaftertheendofthe
firmperiod,theFPSOContractor,SBM,enteredintoacontractwithENItoredeploytheunit
on another field nearby. ExxonMobil being a minority partner of ENI in the new field, the
redeploymentalternatewasconsideredmoreattractiveforExxonMobilthankeepingitpro
ducing at its original location. But one could imagine that without such alternate plan, the
FPSOwouldhavebeenkeptonsiteandExxonMobilwouldhaveexerciseditsoptionstoex
tend.

Theanalysisofthedatasetleadsustothefollowingconclusions.Optionstoextendarevery
frequentlyexercisedbyOilCompanies.InthefewcaseswheretheFPSOleaseisnotextend
ed,theOilCompaniesexercisetheiroptiontopurchasetheunit.TheprobabilityforanFPSO
Contractor of having an idle FPSO at the end of the firm period is therefore deemed very
low.Beyondthisfirstconclusion,onemayhypothesizethatthereasonwhyoptionsaremas
sivelyexercisedbyOilCompaniesisbecausetheyaresocheaplypricedbyFPSOContractors.

Furthertothisanalysiscarriedoutatamacroscopiclevel,itwouldbeinterestingtorevisitit
atafinerlevel.TheexerciseofoptionscouldbeanalyzedatthelevelofOilCompanies.This
could possibly lead to conclusions on the behavior and the risk aversion of the various Oil
Companies.

3.4 BEYONDCONTRACTUALOPTIONS
TheoptionsincludedinFPSOleasingcontractsoffersignificantflexibilitytoOilCompanies.It
allowsinparticulartoadaptthedurationoffieldproductiontotheactualconditionsfaced:
oil prices and reservoir quality. Oil Companies have a prudential approach when fixing the
firm period duration. It generally represents the duration during which production is be
lievedtobeprofitableconsideringthemostpessimisticcasescenarioenvisagedpriortothe
fielddevelopment.TheJubileeFPSOcaseisaclearillustrationofthisapproach.Similarlythe
Contractor BWO states in its 2009 annual report: It is common for customers, i.e. the oil
25
companies,tocontractthefirmperiodfortheFPSOleasecorrespondingtotheexpectedpro
ducinglifeofthereserves.

Thereishoweveronecasewheretheoilfieldprovedtoproducelessoilthanforecastedby
theOilCompanyinitspessimisticscenario.OnthefieldofGolfinhoinBrasil,theOilCompa
ny Petrobras had concluded a contract with SBM for leasing the FPSO Capixaba. The firm
durationwas7yearswith3optionsofoneyear.Theoilfieldoutputprovedhowevertobe
very disappointing after production started with Capixaba FPSO. Petrobras therefore pro
posedSBMtorelocatetheFPSOtoanotherfieldwithintheframeworkofthesamecontract
butwithrevisedcommercialconditionstoaccountfortheFPSOupgradecosts.

Another case of direct agreement between Company and Contractor is the FPSO Falcon.
ExxonMobilhadcontractedwithSBMforafirmperiodof6years.Nooptionforextensionof
the leasewasincludedinthe contract(sourceSBMpresentationof 2004Full Year Results).
Lateron,ExxonMobilnegociatedtoextendtheleaseforoneyearuntilDecember2009.

Itcomesoutfromthe2aboveexamplesthatOilCompanieshaveopportunitiestoadaptthe
FPSO lease beyond the initial contract. But the commercial conditions of such changes are
mostprobablymoreexpansivethanitwouldhavebeenunderacompetitivebid.

4 VALUATIONOFOPTIONSTOEXTEND
GiventhesuccessofoptionsinLeasingcontracts,havingpropertoolstovaluethoseoptions
is a must for well managed FPSO Contractors. The traditional pricing FPSO lease contracts
withDCFmodelsremainsacostdrivenonlyapproach.Assessingthevaluecreationpotential
of the options for the Oil Company is a new interesting approach that we propose. For the
FPSOContractor,itshouldbeconsideredasamajortoolfordefiningimprovedpricingstrat
egies.Thissectionpresentsanewframeworkforvaluingoptionstoextend.Itdiscussesthe
parallelwiththetheoryoffinancialoptionsandanalysesthemaindifferenceswiththeusual
realoptioncasesthroughtheuseofsimplecases.Aconcreteexampleofavaluationmodel
isthenproposedwithnumericalsimulations.Finallythenewvaluationmethodiscomment
edfromamanagerialperspectiveandfuturedevelopmentareconsidered.

4.1 AMOVETOWARDVALUEFORFPSOCONTRACTORS
ThetraditionalapproachusedbyFPSOContractorsforpricingleasecontractsistoapplythe
DCFmethod.Thiscostdrivenapproachisbasedonthecostestimateofcapitalexpenditure
required to provide the FPSO. We believea value driven approach should be considered to
26
complement the classical DCF analysis. Offering options to Oil Companies creates value for
them. Through the options they can benefit from positive conditions (high oil prices, in
creaseofrecoveryrate,etc)duringfieldproductionwhilelimitingtheirrisksexposure.Op
tions to extend can thus be seen as creating value for Oil Companies and FPSO Contractor
have legitimacy to receive a share of this created value. Valuation of those options should
therefore be considered as a first step. Ultimately, the result of such analysis should allow
FPSOContractorstobuildpricingstrategiesabletocapturemorefromthevaluecreatedfor
OilCompanies.

4.2 LITERATUREREVIEW
We have searched the existing literature on the valuation of options in FPSO leasing con
tract.Nopreviousworkhas,toourknowledge,alreadybeenpublishedonthesubject.
A number of authors have worked on the valuation of Real Options in Natural Resources
Development. Brennan and Schwartz (1985) proposed a famous model for the valuation of
mines in a production versus closure problem. Most of the papers consider however the
valuation of natural resource prior to the start of production. And more important, valuing
FPSO leasing contract and its options has only an indirect link with the value of the natural
resource,inourcasetheoilfield.
The problem of real asset leasing has been treated first from the perspective of the lease
versusbuydecisionandtheimpactoftaxes,withanimportantcontributionfromMyers,Dill
and Bautista (1976). Grenadier (1995) adopted a real option approach to value the leasing
contract:leasinganassetforafixedperiodTisequivalenttoaportfoliowhichincludesthe
assetandaEuropeanputoptionwithastrikepriceofzeroattheexpiryT.
RecognizingtheapproachofMyers,DillandBautista(1976)wasnotsuitableforvaluingthe
variousoperatingoptionsofleasingcontracts,Trigeorgis(1996)proposedanotherapproach
with contingent claims analysis and suggested a numerical approach. Options in lease con
tractscanbeseenasclaimswhosevalueiscontingentonthefuturevalueoftheleaseas
set(Trigeorgis,1996).Anoptiontobuytheassetattheendoftheleasingisequivalenttoa
call option. An option to extend is similar to a lease contract with a longer fixed period to
getherwithanoptiontocancelwithnopenalty.
ItisinterestingheretonotethatvalueofoptionsinFPSOleasecontractiscontingenttothe
futurevalueoftheoilfieldandnotoftheFPSOwhileTigeorgis(1996)consideredthefuture
valueoftheassetonly.ThemainargumenttolinkthevalueoftheFPSOleaseoptionstothe
oneoftheremainingoiltobeproducedistheveryhighcostofmobilizationofanewFPSO.
Morerecently,JorgesenandDeGiovanni(2010)useanapproachsimilartoTrigeorgis(1996)
for the valuation of time charter contracts with purchase options in Shipping. The value of
the ship is derived from the charter spot rate using a mean reverting process forspot rate.
27
The various options are then valued based on the future ship value. Jorgesen and De Gio
vanni conclude their paper with proposing as possible future research a multifactor model
asopposedtotheirsinglefactormodelrelyingonthecharterspotrate.InourcaseofFPSO
leasing, the value of the oil field being produced can be seen as a 2 factor model. The oil
priceandtheremainingquantityofoiltobeproducedareindeedthe2mainsourcesofun
certainty.

Giventhepresentstateoftheresearchonthesubject,wefirstillustratethespecificitiesof
FPSOleasingoptionswithtwosimplemodelsanddecisiontreeapproach.Thenwepropose
andcommentanumericalmethodtoapproximatethevalueofoptionstoextendbasedona
MonteCarloapproachandasimplifiedstoppingrule.

4.3 EXPLORINGSIMPLECASES
4.3.1 SINGLEONEYEAROPTIONTOEXTEND
Letusconsiderherethesimplecaseofafirmleasingperiodofnyearsandonlyoneoption
toextendtheleasebyoneyear.

Theanalogywithafinancialcalloptionisinteresting:
Long=theOilCompanybuytherighttoextend
Call=righttoproducewiththeFPSOforoneyearcanbeseenastherightto
buyanadditionalquantityofoil.Heretheadditionalquantityisunknownasproduc
tionforyearn+1isuncertain.
Underlyingasset=theprojecttoproducetheoilfieldwiththeFPSO
StrikepriceK=rateforleasingtheFPSOoneyearplusotherCompanyOPEX
Expirationdate=lastdayofyearN
Payoff=zeroor(actualvalueoftheproductionofyearN+1K)

Atyearn+1,weconsideronlytwopossiblestates:
TheoptionisexercisedandtheFPSOleasedduringyearN+1
TheoptionisnotexercisedandproductionstopsattheendofyearN

28

GRAPH9DECISIONTREEFORAONEYEAREXTENSIONOPTION(SOURCE:THEAUTHOR)

We consider a simplified decision rule. The Company exercises the option if the expected
payoffispositive,saidotherwiseiftheexpectedincomefortheyearN+1isgreaterthanthe
operatingexpenses:

E|0il Pricc
N+1
] E|ProJuction
N+1)
] > FPS0 Joyrotcs +otbcr opcroting cxpcnscs

It is interesting to note that the actual payoff can only be known after the option is exer
cised,oncethequantityofoilproducedduringyearN+1issoldatthemarketpriceprevail
inginyearN+1.Aconsequenceisthattheactualpayoffcanbenegativeiftheactualincome
islessthanthestrikepriceK.Theoptionpayoffincaseofexerciseisthereforeasshownin
Graph 10, but with a probability of negative payoff remaining low. It corresponds to the
conditional probability of getting an actual negative payoff for year N+1 whereas the ex
pectedpayoffforthesameperiodwasgreaterthan0atyearN.

29

GRAPH10PAYOFFOFAONEYEAREXTENSIONOPTION(SOURCE:THEAUTHOR)

4.3.2 SEVERALONEYEAROPTIONSTOEXTEND
Furthertothefirstcase,letusnowdescribeasecondcasewiththefollowingcharacteristics:
afirmperiodofNyearsandtwo1yearoptionstoextend.Weconsiderthesameframework
aspreviouslyandthesamedecisioncriteria.
Similarly as in the first case, we consider for the sake of simplicity only two possible states
fortheoilfield:expectedbenefitfortheyearispositiveornegative.

GRAPH11THEORITICALDECISIONTREEFOR2ONEYEAREXTENSIONOPTIONS(SOURCE:THEAUTHOR)
In B, the expected benefit for year N+1 is positive, the option to extend is exercised. The
yearafter, thereare two possiblestates: D andE.InD theexpectedbenefitis positive,the
secondoptiontoextendisexercised.Ontheopposite,theexpectedbenefitisnegativeinC
andtheFPSOisdemobilized.

In C, the expected benefit is negative. The option is not exercised and the FPSO is demobi
lized.ThefurtherstatesFandGdonotpracticallyexistasshowninGraph12astheproduc
30
tion cannot resume easily after the FPSO demobilization in C. In the real world, this corre
spondstothehighcostofremobilizationoftheFPSOandrestartofthefield.

GRAPH12DECISIONTREEWITHPOSSIBLESTATESONLYFOR2ONEYEAROPTIONS(2)

The simplified decision criteria of this case leads to considering only the superiorbranch of
thebinomialtree.Inpractice,aCompanycanhowevercontinueleasingaFPSOeventhough
the short term expectation is a loss. In such case, the Company accepts a short term loss
against the potential for future benefits. The production profile of a field being generally
decliningwiththetime,futurebenefitscanbeexpectedonlyifanincreaseoffutureoilprice
isexpectedorifanupgradeoftheFPSOtoincreasetheproductionisconsidered.Thesimpli
fication made is deemed sufficiently realistic considering the exploratory natureof the pre
sentwork.Amorerealisticdecisioncriteriacouldbeconsideredinafutureresearch.

In order to understand how to value the 2 options to extend the easiest way is may be to
takeanexample.Weconsiderhereastrikepriceof200andtheexpectedincomesaregiven
inthefollowingtable.Eachpathhasthesameprobabilityofoccurrence.

TABLE3EXPECTEDINCOMEFOR2ONEYEAREXTENSIONOPTIONS(SOURCE:THEAUTHOR)

31
AttimeN+2,Path1isinthemoney,i.e.thevalueoftheunderlyingisgreaterthanthestrike
price.The option is exercised and the expected payoff is (230200=30). Path 2 is out of the
money.Theoptionisnotexercisedandthepayoffis0.
At timeN+1,Path 1and Path2arein themoney (pointBofthe abovetree).Theexpected
payoffis(270200=70)andtheoptionisexercised.Path3isoutofthemoney.Theoptionis
notexercisedandtheFPSOisdemobilized.
Oncethedecisionstoexercisetheoptionsaretaken,theFPSOproducesduringtherelated
periodandtheactualincomeoftheOilCompanyareasfollow.

TABLE4ACTUALINCOMEFOR2ONEYEAREXTENSIONOPTIONS(SOURCE:THEAUTHOR)

TheactualpayoffarethencalculatedastheactualincomeminusthestrikepriceK.
TABLE5ACTUALPAYOFFFOR2ONEYEAREXTENSIONOPTIONS(SOURCE:THEAUTHOR)

The earnings of the oil Company are cumulated year after year. The total earning of the
CompanyonPath1are75+10afterexerciseofOption1andOption2.Thepresentvalueof
Path1earningsattimeNarethereforewithadiscountrateR=10%
PI
N
1+2
(Potb1) =
7S
1 + u.1
+
1u
(1 +u.1)
2

SimilarlyforPath2andPath3,
PI
N
1+2
(Potb2) =
7S
1 + u.1

PI
N
1+2
(PotbS) = u

Sothevalueofhavingthetwooneyearoptionsis
32
Ioluc o (0ption 1 +0ption 2) =
1
S
PI
N
1+2
(Potb i)
3
=1

Fa|ue u (Opt|un 1 +Opt|un 2) = 49.

Wecanalsocalculatethevalueonhavingonlyasingleoption.Inthatcase,weconsiderthe
paths1to3untilN+1only,
PI
N
1
(Potb1) =
7S
1 + u.1

PI
N
1
(Potb2) =
7S
1 + u.1

PI
N
1
(PotbS) = u
Fa|ue u (Opt|un 1) =
1
3
8 +
1
3
8 + = 45. 3

ThelaststepistocalculatethevalueofOption2alone.ThevalueofOption2canbeconsid
ered from two perspectives: the value of Option 2 at year N and the value of Option 2 at
yearN+1.ThevalueofOption2atyearN+1isinfactthepresentvalueattimeNoftheex
pectedpayoffofyearN+2discountedattimeNconsideringtheOption1hasbeenexercised.
Indeed,Option2doesnotexistifOptionhasnotbeexercised.ThevalueofOption2atyear
NisthepresentvalueattimeNoftheexpectedpayoffofyearN+2.Inthelattercase,when
calculatingtheexpectedpayoff,oneshallconsidertherealprobabilityofoccurrenceofeach
state of the nature at year N+2 and not the probability of each state conditional to having
exercisedtheprioroption.

Fa|ue u (Opt|un 2) = p

Poyo(Potb i, cor N +k)
(1 +r)
k
2
k=2
3
=1

Withp
1
= p
2
= p
3
=
1
3

Fa|ue u (Opt|un 2) =
1
3

1
(1 +. 1)
2
+
1
3
= 4. 13

Thenumericalresultsconfirmthefollowingequation
33
Fa|ue u (Opt|un 2) = Fa|ue u (Opt|un 1 +Opt|un 2) - Fa|ue u (Opt|un 1)

4.4 AFIRSTATTEMPTTOVALUEOPTIONSTOEXTEND
Asdiscussedin4.2,thevalueofanoptiontoextendinaFPSOleasingcontractiscontingent
to the value of the remaining oil to be produced. Continuing on this idea, we analyze the
optionsvaluefromtheperspectiveoftheOilCompany.Theoptionstoextendgiveflexibility
totheCompany.Wethereforeproposetocomparetwocases,afirstcasewithflexibilityin
theduration(notedO)andasecondcasewithfixedduration(notedF).Theoptionvalueis
thenconsideredasthedifferenceinvaluebetweenCaseOandCaseF.

ThevalueconsideredhereistheNPVobtainedasthesumofDCF.TheDCFanalysisisaclas
sicalapproachusedbyOilCompaniesforvaluingtheirinvestmentinoilfieldsasthenature
of their business leads to a certain visibility on the stream of free cash flows according to
Deloitte(2008).Itisthereforeanaturalapproachforourcase.

WeproposetouseaMonteCarlomethodtosimulatealargenumber,n,ofpossibleoilprice
evolutionsandproductionprofilesforthedurationofanoilfieldlife.Consideringoneofthe
simulationandtheassociatedserialsofaverageoilpriceandtotalproductionforeachyear,
the FPSO leasing contract is extended as long as it remains profitable to do so for the Oil
Company. The simplified decision rule described in 4.3 is applied to extend or not the con
tracteachyearaftertheendofthefirmleasingperiod.Thepayoffsarecomputedeachyear
asthedifferencebetweentheincome,i.e.thequantityofoilproducedduringtheyearsold
attheaverageyearlyoilprice,andtheoperatingexpenses.ThenNPVscanbecomputedfor
thefollowingleasecontracts:
a contract with a firm period of M years, with M being the maximum field life
(NPI
(M0)
)
acontractwithafirmperiodofM1yearsplus1oneyearoption(NPI
(M-11)
),

acontractwithafirmperiodofMkyearspluskoneyearoptionsNPI
(M-kk)
withk
<M

Nowconsideringallthensimulationsofoilpricesandproductionprofiles,theNPVsforeach
lease contracts are calculated in each simulated case and recorded. The expected value of
NPVsarethenobtainedasthemeanoftheNPVcalculatedineachcasei.

34
E|NPI
(M-kk)
] =mean{NPIi
(M-kk)
]
withNPIi
(M-kk)
beingtheNPVcalculatedinthesimulatedcaseiforthecontract
(H -kk)

ThevalueI0
]
oftheoneyearoptiontoextendinyearjisgivenrecursivelyby:
I0
M
= E|NPI
(M-11)
] - E|NPI
(M-10)
]
I0
M-1
= E|NPI
(M-22)
] - E|NPI
(M-20)
] - I0
M

.
I0
]
= E|NPI
(M-]-1]+1)
] - E|NPI
(M-]-10)
] - I0
]+1

Thechapter4.4.1detailshowtheuncertaintiesintheoilpriceevolutionandtheoilproduc
tionprofilehavebeenmodeledasstochasticvariables.Thenchapter4.4.2explainsthesim
ple mathematical model consideredto represent the FPSO leasing contract and theactions
oftheOilCompany.Lastly,chapter4.5.3istheapplicationoftheproposedmethodtoacase
study.

4.4.1 MODELINGUNCERTAINTYWITHSTOCHASTICVARIABLES
4.4.1.1 OILPRODUCTIONPROFILES
Modelingthepossibleproductionprofilesofoilfieldsbasedontheresultsdrillingtestsand
seismic surveys is a discipline in itself. Here our purpose is quite different as an FPSO Con
tractordoesnothaverealisticallyallsuchdataavailable.Soweaimatmodelingtheoilpro
duction uncertainty in a very simple way based on the expected production profile derived
fromtheOilCompanyassessment.
Lund(1999)proposedasimplezerodimensionalreservoirmodelwhileMcCardleandSmith
(1998)tookadifferentapproachbymodelingthedeclinerateasageometricBrownianmo
tion.Hereweproposemodelingtheproductionprofilewithacombinationofaplateauand
adecreasingexponentialfunction.Theproductionuncertaintyisintroducedontheduration
T0oftheplateauandonthecoefficientpofthedecreasingexponentialfunctionwhichare
assumedtofollownoncorrelatednormallaws.
Production = 1 fort<T0
= exp(p.(tT0)) fort>T0

We found out our proposed model fit relatively with some real data provided by the Oil
CompanyTOTALforitsCLOVfield.ThisdatasetwasgivenbyTOTALtoFPSOContractorsfor
35
the design of the CLOV FPSO. The coefficients best matching the CLOV data are p = 0.27
andT0=5.31.
AlsoourmodelfitsrelativelywelltothedataoftheJubileeFPSO.Whenthedurationofthe
plateauisreducedto0,theproductionprofileissimilartothepessimisticcaseenvisagedfor
JubileeFPSO(seeGraph7).

GRAPH13PRODUCTIONPROFILEOFCLOVFPSOMODELEDWITHDECREASINGEXPONENTIALFUNCTION(SOURCE:THEAUTHOR)

The Graph 14 shows 15 simulations of production profiles with T0 and p having standard
deviationsof0.2and0.25respectively.

GRAPH14SIMULATIONOFSTOCHASTICPRODUCTIONPROFILESWITHEXPONENTIALMODEL(SOURCE:THEAUTHOR)
36

4.4.1.2 OILPRICEVARIATIONS
Asdiscussedinchapter2.1.2,oilpriceissubjecttolargevariationsonthemarkets.Historical
datashowsadrasticincreaseofvariabilityduringthelastdecade.Futurevaluesofcrudeoil
spotpricecannotbedirectlyderivedfromcrudeoilhistoricalvalue.Thereishoweverahigh
probability that future behavior would have statistical characteristics similar to the ones of
historicaldata.

Several attempts have been made to model the behavior of crude oil spot price. Geman
(2005)listedseveralmodelsforoilpricesandothercommodities.Thejumpdiffusionmod
el introduced by Merton (1976) accounts for impact of news on the oil spot market that
may generate jump upwards or downwards. Gibson and Schwartz (1990) proposed a two
statevariablemodel.ItconsidersaclassicalgeometricBrownianmotionandcouplesittoa
mean reverting model for the convenience yield. More recently Geman (2000) proposed a
threestatevariablemodelofthefollowingform.

uSt = k (Lt ln St) St +(t) St uw

t
1

JI
t
I
t
= p Jt + o
2
Jw
t
2

J (t) = b(c - (t)) Jt +c_(t) Jw

t
3

Where:
Stisthespotpriceofcrudeoil,
uw
t
1
,Jw
t
2
onJ Jw
t
3
orc brownion motions
(t) = |(t)]
2

Geman comments as follow: A positive drift in the second equation would translate to a
rise on average of the value Lt toward which the commodity spot price St tends to revert,
while this spot price itself may fluctuate significantly around Lt depending on the arrival of
positive or negative news aboutthesituationoftheworld() reserves..The thirdequation
dictates the behavior of the spot price volatility with a second mean reverting model. This
allowsforvolatilityclusteringinoilspotprices.
Inthepresentapproach,wehaveconsideredforsimplicityreasonusinganautoregressive
movingaverage(ARMA)model.Instatisticsautoregressivemovingaverage(ARMA)models
are typically applied to autocorrelated timeseries data. Given a timeseries of data Xt, the
ARMAmodelisatoolforunderstandingand,perhaps,predictingfuturevaluesinthisseries.
37
The model consists of an autoregressive (AR) part and a moving average (MA) part. The
modelisusuallythenreferredtoastheARMA(p,q)modelwherepistheorderoftheauto
regressive part and q is the order of the moving average part. Although ARMA models are
known to have disadvantages compared to other models such as GARCH for modeling oil
prices(Sadorsky2006),weselecteditforourpurposeduetoitssimplicity.Itwouldbeinter
estinginfutureresearchtoconsidermorecomplexandrealisticmodels.
TheBrentindexcorrespondstothepriceofNorthSeacrudeoilandisoneofthemostused
reference indexes. The Brent index daily prices are highly autocorrelated as shown in Ap
pendix4.AnARMAmodelisthereforeappropriate.Byaniterativeprocess,wefindthepa
rameterspandqthatbestmatchtheBrenthistoricaldata:p=2andq=2.Thecoefficientsof
theARMA(2,2)modelarecalculatedusingtheARIMAfunctionimplementedinthestatistical
softwareR.Therelevanceofourchoiceisthentestedwithpositiveresultsusingthemethod
oftheresidues(seeAppendix4).
Graph 15 represents the Brent historical data from 2002 until 2011 in black and 5 simula
tionsoffutureoilpricesusingtheARMA(2,2)modelfortheperiod20122020.

GRAPH15SIMULATIONOFSTOCHASTICOILPRICESWITHARMA(2/2)MODEL(SOURCE:THEAUTHOR)

4.4.2 MODELOFOILCOMPANYOPERATINGALEASEDFPSO
The second part of our approach relies on modeling an Oil Company operating an oil field
withaleasedFPSO.ThemodelshallreflectthebehavioroftheCompanywhentakingdeci
sions to extend the leasing contract. Givena particular evolution of the oil price and a pro
duction profile, the model output will be the value of the oil field from the Company per
spectiveasfirstintroducedin4.4fordifferentconfigurationsofFPSOleasingcontract.
Themodelisbuiltonthefollowingmainfeatures:
38
AFPSOisleasedforafirmperiodwithyearlyoptionstoextend.
The FPSO oil production for each year is an input to the module. It is given as a
productionprofile:dailyoilproductionchangeseachyear.
TheOilCompanyexpensesaretheFPSOleasingratepaiddailyandtheoperating
expenditures made of FPSO OPEX rate and other Company operating expendi
tures.
The Oil Company incomes come from selling the produced crude oil of a given
yearatthecorrespondingaverageyearlymarketprice.
The oil market price is an input to the module as a serial of average values for
eachyear.
The Oil Company is rational: it produces the field until it is not profitable any
more.Ineffect,theOilCompanyexercisesaoneyearoptionifitexpectsthepro
duction tobe profitableduringthe nextoneyear period aftercompletionof the
firmperiod.

ThemodelmainfunctionistodeterminewhethertheOilCompanyexercisesoneorseveral
oneyear options as a function of two main inputs: the production profile and the serial of
yearlyaverageoilprices.Theoutputsofthemoduleare:
NPI
(])
the NPV of a leasing contract with a firm period of j years and i oneyear
options
NPI
(]0)
theNPVofaleasingcontractwithafirmperiodofjyearsandnooptions

Themainlimitationsandassumptionsofthemodelare:
The operating expenditures to be paid by Company and not included in the
FPSO leasing contract have to be estimated. This is used in the model for deciding
whether an option to extend is worth to be exercised or not. In practice, an FPSO
Contractorcanonlyhavearoughestimateofsuchcosts.Abiasisthereforecreated
inthedecisionmakingprocessofthemodel.
OnlyonefieldisproducedbytheFPSO.Thepotentialfortyingbackasatellite
field to the FPSO at afuture stageis not taken into account. In practice, Oil Compa
niescanhavesuchoption.ThiswouldincreasethevalueoftheFPSOleasingcontract
fortheCompanyandconsequentlythevalueoftheoptionstoextendwouldfollowa
similartrend.
TheNPVcalculationaredoneconsideringasinglediscountingratedeemedto
beequaltotheWACCofatypicalOilCompany.Itmaybeadjustedtobetterreflecta
specific Oil Company. Independent relativelysmall oil companies have higher WACC
thanInternationalMajorsuchasExxonMobilorShell.Asthevalueofanoptiontoex
tend decreases with an increase of the discounting rate, this parameter should be
39
takenintoaccountinpracticalcase.SeeinAppendix3theValuationreportofanoil
fieldacquisitionbyDeloittefordetailsonthecurrentWACCofOilCompanies.

4.4.3 CASESTUDY:LEASINGCONTRACTWITHA7YEARFIRMPERIODAND13OPTIONS
To illustrate our method, we consider the case of an FPSO with a daily nominal output of
120,000oilbarrels.Theleasingcontracthasafirmdurationof7yearsandincludes13one
yearoptionstoextend.Theoverallmaximumfieldlifeis20yearsasallfacilities(FPSO,sub
sea structures, etc) are designed for this duration. The dayrate for leasing the FPSO is
600,000 USD. It is valid for both the firm period and the optional periods. The rate also in
cludesaportionrelatedtotheFPSOcontractoroperatingexpenditures(OPEX).OtherOPEX
costsfacedbytheOilCompanyareestimatedtobe50,000USD/day.TheWACCusedis9%.

Wesimulatealargenumber(n=500)ofproductionprofilesandtheoilpricesaregenerated
withtheMonteCarlomethoddescribedpreviously.Foreachsimulation,theNPVsarecom
putedandrecorded.

TheNPVsarecalculatedforthefollowingcases:
firmduration=19yearswith1oneyearoption
firmduration=18yearswith2oneyearoptions

firmduration=7yearswith13oneyearoptions

Theresultsofthe13caseswith500simulationsrunforeacharegiveninthetablehereaf
ter.Thevalueoftheoneyearoptionsarecomputedbackwardfromthevalueoftheoption
toextendduringyear20.

I0
19
= E|NPI
(191)
] - E|NPI
(190)
]
I0
18
= E|NPI
(182)
] - E|NPI
(180)
] - I0
19

I0
]
= E|NPI
(M-]-1]+1)
] - E|NPI
(M-]-10)
] - I0
]+1

I0
7
= E|NPI
(713)
] - E|NPI
(70)
] - I0
8

40
TABLE6RESULTSOFMONTECARLOSIMULATIONFORVALUATIONOFOPTIONSTOEXTEND(SOURCE:THEAUTHOR)
Firmdu
ration
(Years)
Number
of1year
Option
NPVo
E|NPI
(M-]-1]+1)
]
NPVf
E|NPI
(M-]-10)
]
PresentValueof
thefirst1year
option
(1) (3) (4)=(1)(3)(4)
19 1 8311865 8261581 50284
18 2 8233332 8112250 70798
17 3 8421472 8219934 80456
16 4 8208251 7922540 84173
15 5 8326279 7922032 118536
14 6 8349755 7789309 156199
13 7 8256363 7540944 154973
12 8 8392486 7492492 184575
11 9 8414676 7221147 293535
10 10 8233161 6740052 299580
9 11 8339269 6490036 356124
8 12 8228615 5994740 384642
7 13 8348727 5507789 607063

Total 2840938

The numerical results lead us to the following main observation: the value of the options
decreasewiththeirtimehorizon.Thevalueoftheoptiontoextendfortheyear8isindeed
greaterthantheoptiontoextendfortheyear11.Severalreasonscanexplainthisphenom
ena.First,thediscountingfactorappliedtotheoptionforyear11issmallerthantheonefor
the year 8. Also, as production decreases with the time, the potential income for year 8 is
therefore generally greater than for subsequent years. Lastly, the value of the first option
includesthepotentialforsubsequentoptions.Sotheoptionforyear19includesinitsvalue
thepotentialoftheoptionforyear20.Thesameappliesfortheoptionforyear18withthe
valueofoptionsforyear19and20.Recursively,theoptionforyear8includesthepotential
foroptionsofyear8,9,10,till20.

5 MANAGERIALCOMMENTS
At this point of the analysis, it is worth taking some distance with the approach and the
modelproposedandspendingsometimeondiscussingthefindingsfromamanagerialpoint
ofview.

The first main element highlighted is the proven risk aversion of Oil Companies. Options to
extendleasingcontractsarebynaturetobeexercisedshouldtheoilfieldsdeliverasperthe
41
expectations. The management of an FPSO Contractor may therefore base its investment
scenarioonthemostprobablecase:atleastsomeoftheoptionswillbeexercised.Therisk
associatedwithsuchinvestmentscenariowouldbeinverselycorrelatedtotheriskaversion
oftheOilCompany.AhighlyriskaverseOilCompanywillconsiderafirmperiodmuchshort
er than the expected field production duration. The risk of the lease contract being termi
natedafterthefirmperiodisthereforeverylimited.Thehighertheriskaversion,thesmaller
therisktakenbytheFPSOContractor.

Thevalueofoptionsdecreaseswiththeirtimehorizons.Optionscanbeofimportancewhen
thefirmperiodofthecontractisshortandrepresentonlyafractionoftotalpotentialdura
tionofthelease.Insuchcaseonly,thepropervaluationofoptionsisparamount.Theoppo
site situation is for example a lease with a 15 year firm period and 5 options to extend by
oneyear.Thetimehorizonoftheoptionsbeingafter15years,itspresentvalueforboththe
OilCompanyandtheFPSOContractorwouldbenegligible.

Anotherimportantparameter is theoilprice trend.Whatevertheshort termtrends shown

by the Brent index, the current economic environment is believed to lead toward a long
term increase of oil prices. This may not be true at a 30 year time horizon as technological
jumps may change the central role of oil in the economy. But considering 10/15 year time
horizon, oil prices are believed to follow a trend toward higher values. Hence the value of
optionsshouldincrease.

Coming back to the favorable case of a short firm period, 5 years for example, the options
carrysignificantvalue.Thetraditionalpricingapproachwouldbetoproposeafixedratefor
the firm period and then declining rate for the subsequent years calculated from the non
depreciatedpartoftheFPSOfromanaccountingpointofview.Itwouldbeinterestinghow
evertoconsideradifferentpricingstrategy.Thedayrateforthefirmperiodwouldbefixed
at a lower level. This would increase the competitiveness against the standard approach at
thecostofahigherriskincaseofterminationattheendofthefirmperiod.Theratesforthe
options would however be increased to compensate for the decrease of the fixed rate.We
couldexpectthenewpricingstrategytotakeadvantageoverthestandardpricingapproach.
Should a FPSO Contractor go this way, its risk profile would change. It may deliver higher
profitsoverallbutwithahigherrisk.

The limits of the proposed model for valuing options should however be kept in mind. Im
portantassumptionshavebeenmadeontheproductionprofiles,theoilpriceandoperating
costsfacedbyCompany.SuchinformationisnormallynotavailabletoFPSOContractorsdur
ing a bidding process. At best it can only make a rough estimate of the production profiles
42
andofCompanyoperatingcosts.Themodelshouldthereforebeseenmoreasaninteresting
toolforanalysisthanasatruevaluationtool.

6 CONCLUSION
This analysis of the value of options embedded in FPSO leasing contracts recognizes the
complexityofthecontextcharacterizedbylargeunderlyinguncertaintiesandhighriskaver
sionoftheparticipants.Ourstudieshaveshownthatincertainsituation,apropervaluation
of the options would provide interesting insights to FPSO Contractor for building new com
petitivepricingstrategies.Thelimitsofourstudiesandthepossibleimplicationsformanag
ersofFPSOContractorshavebeendiscussedinSection5.
Among the several directions for future research mentioned throughout the paper, we
would recommend trying a realoption approach with a more realistic decision criteria. An
other direction would be the study of Oil Company risk aversion and the potential applica
tiontobiddingstrategies.

43
Glossary

FPSOContractororContractor:afirmowningoneorseveralFPSOwhichareleasedoravail
ableforleasingtoOilCompanies.LeadingFPSOContractorsareSBMandMODECasdetailed
inAppendix1.
Majors:termcommonlyusedtonamethebiggestinternationalOilCompaniessuchasExx
onMobil,Chevron,ShellorBP
OilCompany:afirmperformingexplorationactivitiestoidentifynewoilfieldsandproducing
crude oil from the discovered fields. It includes large international companies such as the
ExxonMobil,Total,national companiessuch as PetrobrasorSaudi Aramco,andsmallinde
pendentfirmsthatoperatesinlimitednumbergeographicalareasandonlyfewfields.
Subsea structures: located on the sea bed of an offshore oil field, it includes all pipelines,
manifolds, and other systems to transmit the fluid from the wells to the production plat
form.

Abbreviations
CAPEX:CapitalExpenditures
DCF:DiscountedCashFlow
FPSO:FloatingProductionStorageandOffloadingunit
NPV:NetPresentValue
OPEX:OperatingExpenditures
USD:UnitedStatesDollars
WACC:WeightedAverageCostofCapital

44
Bibliography
Brennan M. and Schwartz E.,Evaluating Natural Resources Investment, The Journal of
Business,(vol58,1985)
ExtractofAcquisitionofShellsNorthWestShelfoilinterestsIndependentexpertsreport
byDeloitte19February2008
GrenadierStevenR.,Valuingleasecontracts,Arealoptionsapproach,JournalofFinancial
Economics(n38,1995)
HeleyetteGeman,CommoditiesandCommodityderivatives,modelingandPricingfoAgricul
turals,MetalsandEnergy,WileyFinance,2005
JohnC.Hull,Options,FuturesandOtherDerivatives,Pearson,2012
JorgensenP.L.andDeGiovanniD.,TimeCharteswithPurchaseOptionsinShipping:Valua
tionandRiskManagement,AppliedMathematicalFinance(Vol.17,No.5,October,2010)
Lombardo Lucia,"Overview of Floating Production, Storage and Offtake (FPSO) Services
Agreements",AustralianResourcesandEnergyLawJournal(n468,2003)
MyersS.C.,DillD.andBautistaA.,Valuationoffinancialleasecontracts,JournalofFinance
(n31,1976)
Sadorsky, P., Modeling and forecasting petroleum futures volatility, Energy Economics,
(n282006)
TrigeorgisL.,Evaluatingleaseswithcomplexoperatingoptions,EuropeanJournalofOpera
tionalResearch(n91,1996)

45
Appendices

Appendix1:StructureoftheFPSOLeaseMarketsupplyside
Appendix2:FactualDataonLeaseContracts
Appendix3:ExtractfromDeloittesreportonAcquisitionofShellsNorth
WestShelfoilinterests(2008)
Appendix4:OilPricesModelwithArma(2,2)

46
Appendix1:StructureoftheFPSOLeaseMarketsupplyside
TheFPSOleasingmarkethasexperiencedbigchangesoverthelasttenyears.Fromanoli
gopolisticsituation,themarkethasevolvedtowardacompetitivemarketwithmorethan16
ofcontenders.Backinyear2000,thefewactiveplayerswereSBM,BWOffshore,Modecand
Bluewater.TherewasarelativelylowcompetitionbetweenContractorsaseachhadadomi
nantpositioninaparticulargeographicalmarket.ThiswasclearlystatedinSBMAnnualRe
portforYear2000:InthemarketofFPSOsonaleaseandoperatebasis,thereisstilla
limitedbutsignificantnumberofcompetitorsforthemorecomplexsystems.Theseinclude
ModecofJapan,BluewateroftheNetherlands,MaerskContractors(Denmark),PGSofNor
way(theownerofGolarNor),andNortrans.Nowthesituationisratherdifferent.InSBM
presentationtofinancialanalystdatedNovember2011,16FPSOContractorsowningatleast
2FPSOsarelisted.Althoughthefourleadingplayershavesignificantlylargerfleets,other
firmssuchasSAIPEMorBumiArmadaarepartofthecompetition.Inaddition,theexcessof
marketcapacitycomparedtocurrentdemandhighlightedinSBMpresentationhasanin
creasingeffectoncompetition.

47
Appendix2:FactualDataonLeaseContracts

DatacollectedfromannualreportsofBWO,MODECandSBMfortheperiodfrom2000until
2010andwebsitesofthesameContractors.
N
FPSO
CONTRACTOR
FPSOName
Firm
Duration
(Year)
Optionsto
Extend
(Year)
Leasing
StartDate
LeasingEnd
Date
Options
exercised
(Year)
1 SBM Firenze 5,5 4 03/03/1998 30/04/2006 2,7
2 SBM Kuito 5 5 15/12/1999 01/12/2009 5,0
3 SBM Espadarte 8 5 03/07/2000 01/06/2013 4,9
4 SBM Brasil 5,5 4 07/12/2002 01/05/2012 3,9
5 SBM Xikomba 7 6 31/10/2003 01/06/2011 0,6
6 SBM MarlimSul 8 2 07/06/2004
7 SBM BarinovMOPUPetronas 3 2 08/03/2006 01/07/2009 0,3
8 SBM Capixaba 7 3 06/05/2006 01/04/2010
9 SBM Kikeh 8 15 17/08/2007
10 SBM Mondo 15 0 01/10/2007
11 SBM Saxi 15 0 01/03/2008
12 SBM EsperitoSanto 15 0 01/03/2009
13 SBM TantawanExplorer 10 1,5 01/01/1997 01/08/2008 1,6
14 SBM RangDong 3 7 01/09/1998 01/09/2008 7,0
15 SBM Falcon 6 0 06/12/2002 01/12/2009 1,0
16 MODEC Buffalo 3 2 2
17 MODEC JasmineMV7 2,5 4,5 01/06/2005 01/06/2011 3,5
18 MODEC Langsa 2 5 01/11/2004 01/11/2011 5,0
19 MODEC CuulongMV9 5 5 01/10/2003 01/10/2008 0,0
20 MODEC Baobab 10 10 01/08/2005
21 MODEC ModecVenture1 2 8 01/08/1998 01/07/2007 6,9
22 MODEC ModecVenture11 5 10 01/03/2005 1,3
23 MODEC Songdoc 5 5 01/11/2008
24 MODEC JubileeKwameNkrumahMV21 10 10
25 BWO SendjeBerge 4 4 2005 2013 4,0
26 BWO Abo 10 0 2003
27 BWO EspoirIvorien 11 9 2002
28 BWO BergeHelene 7 8 01/02/2006
29 BWO PetrleoNautipa 13 2 2002
30 BWO Azurite 7 8 2009
31 BWO YUMK'AK'NAB 15 3 2007
32 BWO BWCidadedeSoVicenteBrazilP 10 5 2009
33 BWO CidadeDeSoMateus 9 6 2009
34 BWO Polvo 7 8 2007
35 BWO BWPioneer 5 3 2011
36 BWO NingalooVision 7 8 2010
37 BWO Umuroa 8 7 2007
38 BWO BWAthena 3 8 2011
39 BWO BWJokoTole 9 4 2012
40 BWO BergeOkoloba 4 4 01/02/2005 01/04/2009 0
48
Appendix 3: Extract from Deloittes report on Acquisition of Shells North
WestShelfoilinterests(2008)

49

50

51
52

53
Appendix4:OilPricesModelwithArma(2,2)

1)AutocorrelationoftheBrentIndex

2)BestfittingARMAmodelforBrenthistoricaldata

CoefficientsofARMA(2,2)modelfortheBrentIndex.
ar1 ar2 ma1 ma2 intercept
1.15 0.154 0.12 0.022 80.6

3)AdequationofselectedmodelwithHistoricalData
ThegraphshowsthedifferencebetweenthehistoricalvalueoftheBrentIndexandthebest
fittingARMAmodel.Inabsolutevalue,theresidusarecenteredinzeroandwithastandard
deviationofabout1.5USD.ConsideringtheBrentIndexaverageofabout70USDperbarrel
over the period, the residues are within 2% of the Index value which is deemed very ac
ceptable.
54