Managing a Portfolio of Real Options: Sequential Exploration of Dependent Prospects

We consider the impact of sequential investment and active management on the value of a portfolio of real options. The options are assumed to be interdependent, in that exercise of any one is assumed to produce, in addition to some intrinsic value based on an underlying asset, further information regarding the values of other options based on related assets. We couch the problem in terms of oil exploration, where a discrete number of related geological prospects are available for drilling, and management’s objective is to maximize the expected value of the combined exploration campaign. Management’s task is complex because the expected value of the investment sequence depends on the order in which options are exercised.