Uncertainty & Irreversible Investment: An Empirical Analysis of Development of Oilfields on the UKCS

Irreversible investment under uncertainty has recently received a considerable amount of attention in the theoretical literature [McDonald and Siege1 (19861, Dixit (1989, 1991), Pindyck (1988, 1989), Ingersoll and Ross (1990)’ Bertola (1990)]. When an investment decision is costly to reverse and the payoffs are uncertain, the investment decision involves comparing the value of investing today with the present value of investing at all possible times in the future. The investment expenditure involves the cost of ‘exercising the option’ to invest at any time in the future and a project is adopted only when the expected payoff exceeds the cost by an amount equal to the value of the option. Option pricing techniques have been used to examine the determinants of irreversible investment under uncertainty, and show that even risk-neutral firms may be reluctant to invest when the future is uncertain. Oil investment in the North Sea is an example of irreversible investment. It involves three separate but highly interrelated activities: exploration, development of the oilfield, and extraction, We claim that on the United Kingdom Continental Shelf (IJKCS) the irreversible decision is made when development is undertaken. In other words, the exploration activity provides the firm with the option to invest, whose value is affected by the uncertainty that surrounds future oil prices.

By: C. A Favero , S. Sharma , M. Hashem Pesaran

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