We develop a framework for valuation and optimal decision making in oil exploration projects with uncertain surroundings. In particular, we construct a real options valuation framework that incorporates the stochastic process of the oil price, on-going exploration costs subjected to an uncertain time to completion of the exploration, and the total amount of oil in the field. First, we outline a model including an abandonment option. If abandoned, we let the owner sell the project to another player in the market. Then, we extend the model by including an option to delay the final investment cost when the exploration is completed. Furthermore, we find the optimal threshold levels for the oil price at which the project should be invested in or abandoned. Despite the elements of flexibility involved, and the uncertainty in oil prices and time to completion, we are able to obtain simple closed form solutions. We find that by allowing the owner to sell the project at abandonment, the total project value and the abandonment threshold level increase. However, the effect is diminishing with the oil price. The option to delay the final investment increases the project value but lowers the abandonment threshold level. Finally, we perform sensitivity analysis by changing important input parameters, such as the expected time to completion of the exploration stage and the total amount of oil in the field. The focus of the thesis is on the petroleum industry, and the Norwegian continental shelf in particular. However, the framework and the possible closed form solutions are applicable to a wide range of investment cases, such as R&D projects and projects involving other natural resources.
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