Corn Ethanol Plant Investment and Divestment Decisions: A Real Options Approach

This research attempts to explain the boom and bust of corn ethanol plants in the mid-2000s by analyzing the following question: Did investors use a simple investment approach that suggested it was wise to invest, while more complex techniques would have shown to wait? To answer this, the authors construct ethanol-corn gross trigger margins that tell investors when to invest in and plant owners when to mothball, reactivate, or sell an ethanol plant. These trigger margins are obtained using a net present value technique, a real options framework under the assumption that gross margins follow Geometric Brownian motion, and a real options framework under the assumption that gross margins follow a mean-reverting stochastic process. Trigger margins are then compared to actual ethanol-corn gross margins to determine which investment evaluation technique investors appeared to use. Using corn and ethanol price data during 1998-2008 and cost data for hypothetical ethanol plants, the authors find that investors seemed to follow the more complex real options framework assuming gross margins followed Geometric Brownian motion.