Valuing forestry agronomic potential under seasonal mean-reverting prices

Abstract

In the valuation of forest resources, the alternative uses of the land is one of the central themes. In most cases it is made without taking into account the uncertainty and the possible flexibility of the alternative use. Within these alternatives, the strategy of shifting to a more profitable and sustainable crop is a well-studied topic in forest research. Although the transformation opportunity could add great value to the project, the valuation of this flexibility is obviated by traditional discounted cash flow criteria (NPV). The application of real options theory (ROT) makes it possible to assess this flexibility based on the uncertainty that the transformation entails. However, the hypotheses that are made about the future evolution of the underlying asset, in this case the value of the new crop, may condition the precision of the result. Usually some researchers model these conversions under the hypothesis of Geometric Brownian Motion (GBM), hypotheses that are not plausible when the new crop has a strong seasonal component. In this work, it is proposed an adapted model framework to evaluate forest transformation opportunity into another crop when land use has both high agronomic potential and high seasonal component, context in which classic real options framework is not applicable. As a work based on a theoretical model, after methodological motivation, it is chosen a the strawberry crop as alternative due to its seasonal component. Using private data for this crop, we model through the Ornstein-Uhlenbeck process, with mean-reversion (MR) to a seasonal component, and then we use of Longstaff and Schwartz's Algorithm to calculate the option value. The results show that when considering flexibility into option valuation it leds to an increase on the return of more than 4%. Furthermore, robustness analysis evidence that option value is very sensitive to seasonal component, reinforcing previous evidence that suggests that MR process offers a more accurate and appropriate valuation over the traditional GBM in the arena of agronomic potential valuation. Specifically, the result of valuing this transformation through the MR process is between 1.5 and 1.7 times the value of the NPV, which results in approximately 13% annual return. If GBM had been used, the valuation would have been a 72% annual return, an unrealistic result in this context, due to the non-consideration of the seasonal mean-reverting prices process.

Keywords: Land agronomic potential; Ornstein-Uhlenbeck process; real options; sustainable land use.

JEL Classification: C15, C32, C53, G13, G31 and Q14.