Monte Carlo valuation of natural gas investments

• Author: Luis M. Abadie,José M. Chamorro
• DOI: http://doi.org/10.1016/j.rfe.2008.10.002
• Date: 01 January 2009
• Published date: 01 January 2009

Monte Carlo valuation of natural gas investments

Luis M. Abadie

a,1

, José M. Chamorro

b,

⁎

a

Bilbao Bizkaia Kutxa, Gran Vía, 30, 48009 Bilbao, Spain

b

University of the Basque Country, Av. Lehendakari Aguirre, 83, 48015 Bilbao, Spain

abstractarticle info

Article history:

Received 26 September 2007

Accepted 1 October 2008

Available online 17 October 2008

JEL codes:

C6

D8

G1

Keywords:

Real options

Power plants

Stochastic revenues and costs

CO

2

allowances

LNG

In this evaluation of energy assets related to natural gas, our particular focus is on a base load natural gas

combined cycle power plant and a liquefied natural gas facility in a realistic setting. We also value several

American-type investment options following the least squares Monte Carlo approach. We calibrate mean-

reverting stochastic processes for gas and electricity prices by using data from NYMEX NG futures contracts

and the Spanish wholesale electricity market, respectively. Additional sources of uncertainty concern the

initial investment outlay, or the option's time to maturity, or the costof CO

2

emission permits.

© 2008 Elsevier Inc. All rights reserved.

1. Introduction

The aim of this paper is to use the real options method to evaluate

energy investments related to natural gas. Energy resource prices are now

at or near record levels. From t he demand side, strong economic growt h in

America,China, and India has placed world reserves under substantial strain.

Fromthe supply side, new discoveries and investments by the industry have

not kept pace. In sum, energy markets are currently very tight,and energy

security concerns are increasingly acute. Therefore, consumers can expect

any external shock to translate into greater volatility of oil and gas prices.

However,we cannot ignore regulatory uncertainties. A decade ago,

the United States decided to break up the vertically integrated

electricity ind ustry (generation, t ransmission, and d istribution).

Basically, the regulators' rationale was to accomplish higher levels of

competition and efficiency at every stage. This process has brought

about a number of deals concerning the buying and selling of assets.

Meanwhile, the European Union has beenpushing ever harder for the

creation of a single market in traditionally fragmentedindustries, such

as energy. As a consequence, several takeovers and mergers have

taken place at the national level within the EU, and even cross-border

mergers and acquisitions are being proposed. In addition, European

power utilities now face a new carbon market (the EU Emissions

Trading Scheme), which, regardless of whether it is seen as a threat or

an opportunity, will no doubt influence firms' decision making.

In the case of energy investments, this uncertain environment is

coupled with either irreversibility considerations, or a chance to defer

investment, or to manage investment in a flexible way. Under these

circumstances, valuation techniques based on the methods for pricing

options (such as Contingent Claims Analysis or Dynamic Programming) are

superior to the traditional approaches that are based on discounted cash

flows [see, e.g., Dixit & Pindyck,1994; Sick, 1995;Trigeorgis, 1996].Our aim

in this paper is to use the real options method to evaluate energy

investments related to natural gas. We evaluate a base load natural gas

combined cycle (NGCC)power plant and an ancillary installation, a liquefied

natural gas (LNG) facility, in a realistic setting. These investments enjoy a

long useful life but requiresome non-negligible time to build. Then we focus

on the valuation of several investment options again in a realistic setting.

Avariety of models have been proposed for representing the stochastic

process followed by commodity prices. Differences among them have to

do with the number of risk factors necessary to describe uncertainty and

the way to specify the convenience yield. According to Schwartz (1997),

three factors (spot prices, interest rates, and convenience yields) are

necessary to capture the dynamics of futures prices. More recently,

Casassus and Collin-Dufresne (2005) have developed a three-f actor model

of commodity futures prices which nests many frequent specifications.

One of them is Schwartz and Smith (2000), who present a model with two

factors, a (mean-reverting) short-term disturbance in prices and a long-

term price level (which follows a Brownian motion). The two factors are

not directly observable, but theymay be conveniently estimated from spot

Review of Financial Economics 18 (2009) 10–22

⁎Corresponding author. Tel.: +34 946013769; fax: +34 946013891.

E-mail addresses: imabadie@euskalnet.net (L.M. Abadie), jm.chamorro@ehu.es

(J.M. Chamorro).

1

Tel.: +34 607408748;fax: +34 944017996.

1058-3300/$ –see front matter © 2008 Elsevier Inc. All rights reserved.

doi:10.1016/j.rfe.2008.10.002

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