Evaluating Natural Resource Investments Under Different Model Dynamics: Managerial Insights

Abstract

We focus on factors that drive the dynamics of commodity prices. We highlight the capital budgeting implications of three highly–cited, nested, multi–factor models for commodity prices that have been successful in empirical investigations. Competing assumptions regarding commodity prices and their convenience yields can account for differences close to 40% on average, and in excess of 60% in cases, in the valuation of typical natural resource investments. These value differences are found to increase with the maturity and the intrinsic value of the investment, and also with the level and the volatility of the resource’s convenience yield. Resources such as oil or copper, that are used for production purposes, usually exhibit high and volatile convenience yields; thus our findings should be more relevant for decision makers in such sectors.

Keywords: Natural resource investment, Real options, Factor models, Commodity prices, least–squares Monte Carlo simulation

JEL Classification: C15, D81, G13, G31, Q30