The Impact of Stochastic Extraction Cost on the Value of an Exhaustible Resource: An Application to the Alberta Oil Sands

Abdullah Almansour,Margaret Insley

doi:10.5547/01956574.37.2.aalm

Abdullah Almansour, Margaret Insley

Open Access

https://doi.org/10.5547/01956574.37.2.aalm

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Abstract

The optimal management of a non-renewable resource extraction project is studied when input and output prices follow correlated stochastic processes. The decision problem is specified by two Bellman equations describing the project when it is currently operating or mothballed. Solutions are determined numerically using the Least Squares Monte Carlo methodology. The analysis is applied to an oil sands project which uses natural gas during extracting and upgrading. The paper takes into account the co-movement between crude oil and natural gas prices and proposes two price models: one incorporates a long-run link between the two while the other has no such link. Incorporating a long-run relationship between oil and natural gas prices has a significant effect on the value of the project and its optimal operation and reduces the sensitivity of the project to the natural gas price process.

Highlights

The real options approach is standard in the literature for valuing assets contingent on uncertain commodity prices
This paper examines the nature of the co-movement of crude oil and natural gas markets in order to more accurately capture the dynamics of stochastic costs
We study the impact of stochastic extraction costs for a non-renewable resource for the case of a prototype oil sands project which uses natural gas as an input

Summary

Introduction

The real options approach is standard in the literature for valuing assets contingent on uncertain commodity prices. In one of the earlier papers to apply the real options approach, Brennan and Schwartz [1985] demonstrated the use of contingent claims analysis for valuing an exhaustible natural resource when the decision-maker has flexibility to choose from multiple modes of operation. The uncertainty in their model came from only one source, the output price. They assumed a fixed extraction cost and that the output price follows Geometric Brownian Motion (GBM)

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