The Value of Operational Flexibility in the Presence of Input and Output Price Uncertainties with Oil Refining Applications

Management Science, 2014 Forthcoming

35 Pages Posted: 13 May 2014

See all articles by Lingxiu Dong

Lingxiu Dong

Washington University in St. Louis - John M. Olin Business School

Panos Kouvelis

Washington University

Xiaole Wu

Fudan University - School of Management

Date Written: May 12, 2014

Abstract

Refining is indispensable to almost every natural resource-based commodity industry. It involves a series of complex processes that transform inputs with a wide range of quality characteristics into refined finished products sold to end markets. In this paper, we take the perspective of a profit-maximizing refiner that considers upgrading its existing simple refinery to include intermediate-conversion flexibility, i.e., the capability of converting heavy intermediate components to light ones. We present a stylized two-stage stochastic programming model of a petroleum refinery to investigate the value drivers of conversion flexibility and the impact of input and output market conditions on its economic potential. Conversion flexibility adds value to refineries by either transforming a non-profitable situation into a profitable one (referred to as purchase benefit) or improving profitability of an already profitable situation (referred to as unit revenue benefit). In a real-data calibrated numerical study, we find the value of conversion flexibility (VoC) to be significant, accounting for 40% of the expected profit with conversion, and the purchase benefit and unit revenue benefit are equally important. Contrary to the intuition that, as a recourse action, conversion offers higher value for greater input price volatility, we find that VoC may decrease in input price volatility due to the differential impacts of increasing price volatility on the purchase benefit and the unit revenue benefit. Refineries also vary in their range flexibility, i.e., the ability to accommodate a narrow or wide range of inputs of different quality levels. Whether the range flexibility increases or decreases the value of conversion flexibility is affected by the direction in which the refinery expands its processing range and the heaviness of crude oils.

Keywords: operational flexibility, oil refining, value of flexibility, stochastic programming

JEL Classification: C61, Q4

Suggested Citation

Dong, Lingxiu and Kouvelis, Panos and Wu, Xiaole, The Value of Operational Flexibility in the Presence of Input and Output Price Uncertainties with Oil Refining Applications (May 12, 2014). Management Science, 2014 Forthcoming. Available at SSRN: https://ssrn.com/abstract=2435797

Lingxiu Dong

Washington University in St. Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1156
St. Louis, MO 63130-4899
United States

Panos Kouvelis

Washington University ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

Xiaole Wu (Contact Author)

Fudan University - School of Management ( email )

No.670, Guoshun Road
Shanghai, 200433
China

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