Blending Under Uncertainty: Option Value of Biofuels Mandates

36 Pages Posted: 13 Feb 2016  

Hamed Ghoddusi

Stevens Institute of Technology - School of Business

Date Written: February 12, 2016

Abstract

The value of a representative ethanol producer that benefits from both low and high gasoline prices 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.

Suggested Citation

Ghoddusi, Hamed, Blending Under Uncertainty: Option Value of Biofuels Mandates (February 12, 2016). Stevens Institute of Technology School of Business Research Paper No. 2731729. Available at SSRN: https://ssrn.com/abstract=2731729 or http://dx.doi.org/10.2139/ssrn.2731729

Hamed Ghoddusi (Contact Author)

Stevens Institute of Technology - School of Business ( email )

Hoboken, NJ 07030
United States

HOME PAGE: http://www.ghoddusi.com

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