Pricing Expropriation Risk in Natural Resource Contracts - A Real Options Approach

Schwartz, Eduardo S.; Trolle, Anders B.

doi:10.2139/ssrn.1090474

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Pricing Expropriation Risk in Natural Resource Contracts - A Real Options Approach

Published in William Hogan and Federico Sturzenegger, eds.: The Natural Resource Trap, MIT press, 2010

28 Pages Posted: 5 Feb 2008 Last revised: 10 Feb 2016

See all articles by Eduardo S. Schwartz

Eduardo S. Schwartz

Simon Fraser University (SFU); University of California, Los Angeles (UCLA) - Finance Area; National Bureau of Economic Research (NBER)

Anders B. Trolle

Copenhagen Business School

Date Written: January 1, 2008

Abstract

We develop a model for pricing expropriation risk in natural resource projects, in particular an oil field. The government is viewed as holding an American-style option to expropriate the oil field, but facing the following three possible expropriation costs: A state-run company may produce oil less cost-efficiently than a private firm, the government may have to pay a compensation to the firm, and an expropriation may trigger lower investor confidence negatively affecting the overall economy. The dynamics of key variables - the spot price, futures prices and volatility - is described by a model proposed and estimated in Trolle and Schwartz (2007). For reasonable parameter values and under market conditions not too different from what has been seen in recent years, the value of the expropriation option can be substantial.

Keywords: Real options, crude oil contracts, expropriation risk

JEL Classification: G13

Suggested Citation: Suggested Citation

Schwartz, Eduardo S. and Schwartz, Eduardo S. and Trolle, Anders B., Pricing Expropriation Risk in Natural Resource Contracts - A Real Options Approach (January 1, 2008). Published in William Hogan and Federico Sturzenegger, eds.: The Natural Resource Trap, MIT press, 2010, Available at SSRN: https://ssrn.com/abstract=1090474 or http://dx.doi.org/10.2139/ssrn.1090474