IDEAS home Printed from https://ideas.repec.org/a/inm/ordeca/v19y2022i3p205-219.html
   My bibliography  Save this article

Forecasts of Prices and Informed Sensitivity Analysis: Applications in Project Valuations

Author

Listed:
  • Babak Jafarizadeh

    (Institute of Geo-Energy Engineering, Heriot-Watt University, Edinburgh EH14 4AS, United Kingdom)

Abstract

From corporate budgeting to public planning, we hear that commodity prices are uncertain and that, when they vary, key investment measures sway with them. However, claiming that commodity prices are outside a firm’s domain of control, corporate decision makers tend to disregard this uncertainty or at best reflect it in naïve sensitivity analyses. Yet, firms should take in the understanding about key uncertain factors to avoid inferior decisions and loss of value. In this paper, we show that the customary practice of analysis with arbitrary “high” and “low” forecasts of prices is inconsistent with the general understanding about commodity price dynamics and the financial theory. To alleviate this, we develop consistent and project-specific forecast of prices that support valuations and decision making.

Suggested Citation

  • Babak Jafarizadeh, 2022. "Forecasts of Prices and Informed Sensitivity Analysis: Applications in Project Valuations," Decision Analysis, INFORMS, vol. 19(3), pages 205-219, September.
    • Handle: RePEc:inm:ordeca:v:19:y:2022:i:3:p:205-219
    DOI: 10.1287/deca.2022.0453
    as

    Download full text from publisher

    File URL: http://dx.doi.org/10.1287/deca.2022.0453
    Download Restriction: no
    File URL: https://libkey.io/10.1287/deca.2022.0453?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    References listed on IDEAS

    as
    1. Myers, Stewart C & Turnbull, Stuart M, 1977. "Capital Budgeting and the Capital Asset Pricing Model: Good News and Bad News," Journal of Finance, American Finance Association, vol. 32(2), pages 321-333, May.
    2. Babak Jafarizadeh & Reidar B. Bratvold, 2021. "Project Valuation: Price Forecasts Bound to Discount Rates," Decision Analysis, INFORMS, vol. 18(2), pages 139-152, June.
    3. Babak Jafarizadeh & Reidar B. Bratvold, 2019. "Exploration economics: taking opportunities and the risk of double-counting risk," Mineral Economics, Springer;Raw Materials Group (RMG);Luleå University of Technology, vol. 32(3), pages 323-335, November.
    4. Eduardo Schwartz & James E. Smith, 2000. "Short-Term Variations and Long-Term Dynamics in Commodity Prices," Management Science, INFORMS, vol. 46(7), pages 893-911, July.
    5. James E. Smith & Robert F. Nau, 1995. "Valuing Risky Projects: Option Pricing Theory and Decision Analysis," Management Science, INFORMS, vol. 41(5), pages 795-816, May.
    6. H. Christopher Frey & Sumeet R. Patil, 2002. "Identification and Review of Sensitivity Analysis Methods," Risk Analysis, John Wiley & Sons, vol. 22(3), pages 553-578, June.
    7. Schwartz, Eduardo S, 1997. "The Stochastic Behavior of Commodity Prices: Implications for Valuation and Hedging," Journal of Finance, American Finance Association, vol. 52(3), pages 923-973, July.
    8. Murray Carlson & Zeigham Khokher & Sheridan Titman, 2007. "Equilibrium Exhaustible Resource Price Dynamics," Journal of Finance, American Finance Association, vol. 62(4), pages 1663-1703, August.
    9. Brennan, Michael J & Schwartz, Eduardo S, 1985. "Evaluating Natural Resource Investments," The Journal of Business, University of Chicago Press, vol. 58(2), pages 135-157, April.
    10. Robert S. Pindyck, 1999. "The Long-Run Evolutions of Energy Prices," The Energy Journal, International Association for Energy Economics, vol. 0(Number 2), pages 1-27.
    11. Lund Diderik, 1993. "The Lognormal Diffusion Is Hardly an Equilibrium Price Process for Exhaustible Resources," Journal of Environmental Economics and Management, Elsevier, vol. 25(3), pages 235-241, November.
    12. Hahn, Warren J. & DiLellio, James A. & Dyer, James S., 2018. "Risk premia in commodity price forecasts and their impact on valuation," Energy Economics, Elsevier, vol. 72(C), pages 393-403.
    13. Leamer, Edward E, 1985. "Sensitivity Analyses Would Help," American Economic Review, American Economic Association, vol. 75(3), pages 308-313, June.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Babak Jafarizadeh & Reidar B. Bratvold, 2021. "Project Valuation: Price Forecasts Bound to Discount Rates," Decision Analysis, INFORMS, vol. 18(2), pages 139-152, June.
    2. Max F. Schöne & Stefan Spinler, 2017. "A four-factor stochastic volatility model of commodity prices," Review of Derivatives Research, Springer, vol. 20(2), pages 135-165, July.
    3. Ozorio, Luiz de Magalhães & Bastian-Pinto, Carlos de Lamare & Baidya, Tara Keshar Nanda & Brandão, Luiz Eduardo Teixeira, 2013. "Investment decision in integrated steel plants under uncertainty," International Review of Financial Analysis, Elsevier, vol. 27(C), pages 55-64.
    4. Marcel Philipp Müller & Sebastian Stöckl & Steffen Zimmermann & Bernd Heinrich, 2016. "Decision Support for IT Investment Projects," Business & Information Systems Engineering: The International Journal of WIRTSCHAFTSINFORMATIK, Springer;Gesellschaft für Informatik e.V. (GI), vol. 58(6), pages 381-396, December.
    5. Miranda, Oscar & Brandão, Luiz E. & Lazo Lazo, Juan, 2017. "A dynamic model for valuing flexible mining exploration projects under uncertainty," Resources Policy, Elsevier, vol. 52(C), pages 393-404.
    6. Dannenberg, Henry & Ehrenfeld, Wilfried, 2010. "Stochastic Income Statement Planning and Emissions Trading," IWH Discussion Papers 4/2010, Halle Institute for Economic Research (IWH).
    7. Davidson Heath, 2019. "Macroeconomic Factors in Oil Futures Markets," Management Science, INFORMS, vol. 65(9), pages 4407-4421, September.
    8. Bernard, Jean-Thomas & Khalaf, Lynda & Kichian, Maral & McMahon, Sébastien, 2008. "Oil Prices: Heavy Tails, Mean Reversion and the Convenience Yield," Cahiers de recherche 0801, GREEN.
    9. Fernando Antonio Lucena Aiube & Ariel Levy, 2019. "Recent movement of oil prices and future scenarios [Movimentos recentes dos preços do petróleo e os cenários futuros]," Nova Economia, Economics Department, Universidade Federal de Minas Gerais (Brazil), vol. 29(1), pages 223-248, January-A.
    10. Secomandi, Nicola & Seppi, Duane J., 2014. "Real Options and Merchant Operations of Energy and Other Commodities," Foundations and Trends(R) in Technology, Information and Operations Management, now publishers, vol. 6(3-4), pages 161-331, July.
    11. Zhu, Lei & Fan, Ying, 2011. "A real options–based CCS investment evaluation model: Case study of China’s power generation sector," Applied Energy, Elsevier, vol. 88(12), pages 4320-4333.
    12. Postali, Fernando A.S. & Picchetti, Paulo, 2006. "Geometric Brownian Motion and structural breaks in oil prices: A quantitative analysis," Energy Economics, Elsevier, vol. 28(4), pages 506-522, July.
    13. Guedes, José & Santos, Pedro, 2016. "Valuing an offshore oil exploration and production project through real options analysis," Energy Economics, Elsevier, vol. 60(C), pages 377-386.
    14. Jilong Chen & Christian Ewald & Ruolan Ouyang & Sjur Westgaard & Xiaoxia Xiao, 2022. "Pricing commodity futures and determining risk premia in a three factor model with stochastic volatility: the case of Brent crude oil," Annals of Operations Research, Springer, vol. 313(1), pages 29-46, June.
    15. Nguyen, Duc Binh Benno & Prokopczuk, Marcel, 2019. "Jumps in commodity markets," Journal of Commodity Markets, Elsevier, vol. 13(C), pages 55-70.
    16. Abdullah Almansour and Margaret Insley, 2016. "The Impact of Stochastic Extraction Cost on the Value of an Exhaustible Resource: An Application to the Alberta Oil Sands," The Energy Journal, International Association for Energy Economics, vol. 0(Number 2).
    17. Alain Bensoussan & Benoit Chevalier-Roignant & Alejandro Rivera, 2022. "A model for wind farm management with option interactions," Post-Print hal-04325553, HAL.
    18. Seiji Harikae & James S. Dyer & Tianyang Wang, 2021. "Valuing Real Options in the Volatile Real World," Production and Operations Management, Production and Operations Management Society, vol. 30(1), pages 171-189, January.
    19. Björn Lutz, 2010. "Pricing of Derivatives on Mean-Reverting Assets," Lecture Notes in Economics and Mathematical Systems, Springer, number 978-3-642-02909-7, December.
    20. Luis M. Abadie & José M. Chamorro, 2009. "Monte Carlo valuation of natural gas investments," Review of Financial Economics, John Wiley & Sons, vol. 18(1), pages 10-22, January.

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:inm:ordeca:v:19:y:2022:i:3:p:205-219. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Chris Asher (email available below). General contact details of provider: https://edirc.repec.org/data/inforea.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.