Real Option Theory Complements the Stage and Gate Process: the Value of Information

Abstract

Abstract Phased project management processes, also known as stage and gate management processes (SGMP), are widely used to macro and micro-manage projects from early evaluation, to sanctioning and close out. These tools tend to disassemble by discipline the activities and decisions disseminated along the life of a project and re-bundle them into standardized sequential phases, with the underlying intention to narrow down uncertainties and multiply the project value. By virtue of the implicit set of routines and checks, SGMPs have successfully brought a great deal of discipline in the allocation of human and financial capital among competing prospects - albeit not enough. Uncertainty is the scapegoat our industry too often resorts to to justify otherwise inexplicable failures. The variability embedded in the oil and gas business (nature, raw materials prices, etc.) undeniably plays to the detriment of our industry's bottom line but it is not the only delinquent in the game. Ultimately, opportunities are passed over on account of inappropriate assessment of the value of uncertainty and of acquiring the information (Value of Information, VOI) necessary to narrow it down. Finance-derived Real Options have long been proposed to guide investment decisions and overcome the limitations of NPV-based approaches. However, Real Options have failed to win proselytes because of undeniable mathematical complication and an ill-fated fame to be too volatile a concept to fit into 150-year old oil and gas industry. A novel approach is presented that complements the structured framework of SGMPs with VOI evaluation. The result is a project management tool that preserves the merits of SGMPs while warranting improved financial discipline. Introduction It is not uncommon for projects to get heavily in the red even before the development phase gets sanctioned. Large amounts of cash get poured in the search for information to narrow down the uncertainty and reveal the "true" value of the project. This work intends to explore the possibility that some project evaluation and management tools (namely the Stage and Gate process in one of its many declinations) may fail to cater - at least in the current forms and shapes - to financially conscious organizations. The fundamental structure and working of these tools is not being questioned for they have established sound fundamentals for managing the evaluation and development of prospects. However, while a radical makeover of these tools may not be necessary, pinpointed surgery could do the job. This would be in the form of introducing a methodology to manage variance in order to quantify the Value of Information, i.e. the capital that can be allocated to acquire information during the SGMP without jeopardizing the financial success of the project. An improved decision making tool will also protect investment choices from managerial instincts and gut feel that, while incorporating invaluable multi-year experience, cannot be codified and duly explained to peers, partners and investors. "Even the firm's CEO's golf score can be a risk hazard (e.g., rash decisions may be made after a bad game or bad projects may be approved after a hole-in-one, believing in a lucky streak)"1. Stage Gate Management Process Description The Stage Gate Management Process (SGMP) approach is widely accepted and recognized as a good management tool for managing complex projects 2. The SGMP is a value driven process that aims at maximizing project value via evaluation steps or gates. Through successive gates, uncertainty is reduced in order to ideally identify the best solution available that is then executed, pending a sanctioning gate, executed.