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Real option valuation of free destination in long-term liquefied natural gas supplies

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  • Yepes Rodri­guez, Ramón

Abstract

This paper presents a real option model for the valuation of destination flexibility in long-term LNG supplies. Stochastic price dynamics in the different markets is modelled through geometric Brownian motion processes. Mean reversion is considered as well as correlation between markets, but instead of the usual correlation in return shocks, a price convergence term is introduced representing the arbitrage streams between markets. Model parameters are estimated from market data on LNG prices by maximum log-likelihood. The goodness of the fit for the proposed model is tested as well as for two alternative models. Confidence intervals for the parameters are given. Results for the model are calculated by Monte Carlo simulation. Frequency distributions for the main results are plotted. The effect of the main parameters of the model is studied (i.e. price volatilities, price convergence, initial prices in the markets, mean reversion, extra transportation costs, number of alternative markets). The value of destination flexibility is found to be an important share of the value of LNG.

Suggested Citation

  • Yepes Rodri­guez, Ramón, 2008. "Real option valuation of free destination in long-term liquefied natural gas supplies," Energy Economics, Elsevier, vol. 30(4), pages 1909-1932, July.
    • Handle: RePEc:eee:eneeco:v:30:y:2008:i:4:p:1909-1932
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    1. Massol, Olivier & Tchung-Ming, Stéphane, 2010. "Cooperation among liquefied natural gas suppliers: Is rationalization the sole objective?," Energy Economics, Elsevier, vol. 32(4), pages 933-947, July.
    2. Sönmez, Erkut & Kekre, Sunder & Scheller-Wolf, Alan & Secomandi, Nicola, 2013. "Strategic analysis of technology and capacity investments in the liquefied natural gas industry," European Journal of Operational Research, Elsevier, vol. 226(1), pages 100-114.

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