AN OPTION PRICING APPROACH TO EXPLORATION LICENSING STRATEGY

Governments in most countries are owners of mineral rights. In order t o exploit their natural resources efficiently, states are normally obl iged to rely on private mining companies. The government has a challen ging task when deciding which exploration opportunities to exercise no w through licensing and which blocks to save for future exploration, A large inventory of proven reserves allows scheduling of the productio n of various deposits more efficiently. But generating proven oil and gas reserves ahead of time entails oil companies and the society incur ring extra costs. The value of exploration for petroleum now must be w eighted against the value of waiting. This paper uses concepts and met hods from option pricing theory to evaluate exploration for deposits o f non-renewable resources. Exploration licensing is valued as a compou nd option, ie as a call option on a call option to develop, with price as the uncertain variable. The Norwegian petroleum licensing framewor k is used as a background for the specific problem approached, but the problem is familiar to most governments acting as owners of natural r esources. Since exploration strategy is the topic of this paper, it is natural to take a look at the many different economic functions explo ration serves in order to put the problem in perspective before the mo del is presented-even though many of the value creating elements are d ifficult to assess numerically and implement in an economic model. (C) 1998 Elsevier Science Ltd. All rights reserved.