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On the timing of non-renewable resource extraction with regime switching prices: an optimal stochastic control approach

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  • Margaret Insley

    (Department of Economics, University of Waterloo)

Abstract

This paper develops a model of a profit maximizing firm with the option to exploit a non-renewable resource, choosing the timing and pace of development. The resource price is modelled as a regime switching process, which is calibrated to oil futures prices. A Hamilton-Jacobi-Bellman equation is specified that describes the profit maximization decision of the firm. The model is applied to a problem of optimal investment in a typical oils sands in situ operation, and solved for critical levels of oil prices that would motivate a firm to make the large scale investment needed for oil sands extraction, as well to operate, mothball or abandon the facility. The paper focuses on the impact of regime shifts on the optimal timing of investment and extraction compared with the case when the possibility of future regime shifts is ignored.

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Bibliographic Info

Paper provided by University of Waterloo, Department of Economics in its series Working Papers with number 1302.

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Length: 37 pages
Date of creation: Aug 2013
Date of revision: Aug 2013
Handle: RePEc:wat:wpaper:1302

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  1. Shan chen & Margaret Insley, 2010. "Regime Switching in Stochastic Models of Commodity Prices: An Application to an Optimal Tree Harvesting Problem," Working Papers 1016, University of Waterloo, Department of Economics, revised Jul 2010.
  2. Esther W. Mezey & Jon M. Conrad, 2010. "Real Options in Resource Economics," Annual Review of Resource Economics, Annual Reviews, vol. 2(1), pages 33-52, October.
  3. Conrad, Jon M. & Kotani, Koji, 2005. "When to drill? Trigger prices for the Arctic National Wildlife Refuge," Resource and Energy Economics, Elsevier, vol. 27(4), pages 273-286, November.
  4. Janczura, Joanna & Weron, Rafal, 2010. "An empirical comparison of alternate regime-switching models or electricity spot prices," MPRA Paper 20546, University Library of Munich, Germany.
  5. Abdullah Almansour & Margaret Insley, 2013. "The impact of stochastic extraction cost on the value of an exhaustible resource: An application to the Alberta oil sands," Working Papers 1303, University of Waterloo, Department of Economics, revised Jun 2013.
  6. Dixit, Avinash K, 1989. "Entry and Exit Decisions under Uncertainty," Journal of Political Economy, University of Chicago Press, vol. 97(3), pages 620-38, June.
  7. Dixit, Avinash K, 1989. "Hysteresis, Import Penetration, and Exchange Rate Pass-Through," The Quarterly Journal of Economics, MIT Press, vol. 104(2), pages 205-28, May.
  8. Slade, Margaret E., 2001. "Valuing Managerial Flexibility: An Application of Real-Option Theory to Mining Investments," Journal of Environmental Economics and Management, Elsevier, vol. 41(2), pages 193-233, March.
  9. Margaret Insley & Kimberly Rollins, 2005. "On Solving the Multirotational Timber Harvesting Problem with Stochastic Prices: A Linear Complementarity Formulation," American Journal of Agricultural Economics, Agricultural and Applied Economics Association, vol. 87(3), pages 735-755.
  10. Andre Plourde, 2009. "Oil Sands Royalties and Taxes in Alberta: An Assessment of Key Developments since the mid-1990s," The Energy Journal, International Association for Energy Economics, vol. 0(Number 1), pages 111-140.
  11. 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 923-73, July.
  12. Larsson, Karl & Nossman, Marcus, 2011. "Jumps and stochastic volatility in oil prices: Time series evidence," Energy Economics, Elsevier, vol. 33(3), pages 504-514, May.
  13. Paddock, James L & Siegel, Daniel R & Smith, James L, 1988. "Option Valuation of Claims on Real Assets: The Case of Offshore Petroleum Leases," The Quarterly Journal of Economics, MIT Press, vol. 103(3), pages 479-508, August.
  14. Avinash Dixit, 1992. "Investment and Hysteresis," Journal of Economic Perspectives, American Economic Association, vol. 6(1), pages 107-132, Winter.
  15. Mason, Charles F., 2001. "Nonrenewable Resources with Switching Costs," Journal of Environmental Economics and Management, Elsevier, vol. 42(1), pages 65-81, July.
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