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Real Option Management of Hydrocarbon Cracking Operations

S. Nadarajah, N. Secomandi, G. Sowers, J. Wassick, Real Option Management of Hydrocarbon Cracking Operations, Real Options in Energy and Commodity Markets, World Scientific-Now Publishers Series in Business, Chapter 5, 173-202, N. Secomandi (ed.), 2017.

Posted: 29 Nov 2014 Last revised: 10 Mar 2017

Selvaprabu Nadarajah

University of Illinois at Chicago - College of Business Administration

Nicola Secomandi

Carnegie Mellon University - David A. Tepper School of Business

Gary Sowers

The Dow Chemical Company

John Wassick

The Dow Chemical Company

Date Written: November 28, 2014

Abstract

Commodity conversion assets play important economic roles. It is well known that the market value of these assets can be maximized by managing them as real options on the prices of their inputs and/or outputs. In particular, when futures on these inputs and outputs are traded, managing such real options, that is, valuing, hedging, and exercising them, is analogous to managing options on such futures, using risk neutral valuation and delta hedging methods. This statement holds because dynamically trading portfolios of these futures and a risk less bond can replicate the cash flows of these assets. This basic principle is not always appreciated by managers of commodity conversion assets. Moreover, determining the optimal operational cash flows of such an asset requires optimizing the asset operating policy. This issue complicates the real option management of commodity conversion assets. This chapter illustrates the application of this approach to manage a hydrocarbon cracker, a specific commodity conversion asset, using linear programming and Monte Carlo simulation. The discussion is based on a simplified representation of the operations of this asset. However, the material presented here has potential applicability to the real option management of more realistic models of hydrocarbon cracking assets, as well as other energy and commodity conversion assets.

Suggested Citation

Nadarajah, Selvaprabu and Secomandi, Nicola and Sowers, Gary and Wassick, John, Real Option Management of Hydrocarbon Cracking Operations (November 28, 2014). S. Nadarajah, N. Secomandi, G. Sowers, J. Wassick, Real Option Management of Hydrocarbon Cracking Operations, Real Options in Energy and Commodity Markets, World Scientific-Now Publishers Series in Business, Chapter 5, 173-202, N. Secomandi (ed.), 2017.. Available at SSRN: https://ssrn.com/abstract=2531678 or http://dx.doi.org/10.2139/ssrn.2531678

Selvaprabu Nadarajah (Contact Author)

University of Illinois at Chicago - College of Business Administration ( email )

601 South Morgan Street
Chicago, IL 60607
United States

Nicola Secomandi

Carnegie Mellon University - David A. Tepper School of Business ( email )

5000 Forbes Avenue
Pittsburgh, PA 15213-3890
United States

Gary Sowers

The Dow Chemical Company ( email )

Midland, MI
United States

John Wassick

The Dow Chemical Company ( email )

Midland, MI
United States

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