Blending under uncertainty: Real options analysis of ethanol plants and biofuels mandates

Hamed Ghoddusi

Energy Economics, 2017, vol. 61, issue C, 110-120

Abstract: The value of a representative ethanol producer, that benefits from both low and high gasoline prices in the short-run, is modeled. Ethanol producers make a modest competitive profit in the mandate-induced region of production. A low price of gasoline increases the demand for blend ethanol and consequently increases the profit of ethanol producers. On the other hand, when gasoline becomes costlier than ethanol, the capacity constraints of the biofuels sector bind and ethanol producers gain large quasi-monopoly margins. This is an interesting example of a market where two commodities are complement up to a point and then substitute after that. We postulate the value of an ethanol producer as a strangle option consisting of two real options: the option to substitute gasoline at times of expensive crude oil and the option to expand supply of blend at times of cheap gasoline. Using a dynamic model we show that the higher volatilities of crude oil and ethanol costs increase biofuels firms' value. We also find non-monotonic relationships between the value of an ethanol plant and several underlying variables, including gasoline price level. We estimate the value provided by a 10% blend mandate to be around $150,000,000 for a representative ethanol unit. Our results offer a novel view of oil and feedstock price risks in contrast to the common belief that considers those risks as a negative factor for the biofuels sector.

Keywords: Biofuels mandates; Valuation; Real options; Strangle option (search for similar items in EconPapers)
JEL-codes: C6 D21 G13 G31 Q41 Q42 (search for similar items in EconPapers)
Date: 2017
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (11)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:eneeco:v:61:y:2017:i:c:p:110-120

DOI: 10.1016/j.eneco.2016.11.007

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