This paper extends financial option theory by developing a methodology for the valuation of claims on a real asset: an offshore petroleum lease. Several theoretical and practical problems, not present in applying option pricing theory to financial assets, are addressed. Most importantly, we show the necessity of combining option pricing techniques with a model of equilibrium in the market for the underlying asset (petroleum reserves). The advantages of this approach over conventional discounted cash flow techniques are emphasized. The methodological development provides important insights for both company behavior and government policy. Promising empirical results are reported.

A current trend among oil-producing nations with private oil sectors is to move toward tax systems that are based upon pr ofits rather than production. The authors present a case study of wha t can go wrong with profit-based tax schemes. They study the implemen tation of the net profit share leasing system in the United States in the early 1980s. They conclude that the information requirements of the scheme are heavy, perhaps prohibitive, and that the net profit sh are system can easily backfire if the informational requirements can not be met. The authors also show that the U.S. government misused th e limited amount of information that was available to it.