Analysis of return on investment in some Niger-Delta oil field projects: using the variance-gamma process

Abstract

Oil field development projects face market risks, largely because the parameter of key importance, the oil price, fluctuates rapidly over time. The decision to invest or not in an oil field project is therefore very challenging, because information concerning the field is often scarce. Neither the future production, nor sales prices are known with certainly. Constraints on production level also exist, in addition to OPEC quota, which is used in this work as proxy for other production limitations. The price process that best describes the fluctuations in oil price is expected to yield better analysis with respect to expected returns (viability of the project). The Variance Gamma process which is a subordinated Lévy process effectively captures jumps in a process. Thus, Variance Gamma process and a mean reverting process are considered in the analysis. The expected revenue was found to be higher, when the variance Gamma process is used as the model for oil price. This indicates that the variance Gamma process performs better than the Ornstein-Uhlenbeck process as a model for oil price. It therefore provides a good basis for price forecasting, and optimality of investment decision.

Keywords: Variance Gamma Process, Mean Reverting Process, Parameters, Niger-Delta Oil Field Projects, Expected Return, OPEC constraint