Flexibility as a source of value in the production of alternative fuels: The ethanol case

There is typically a high degree of flexibility associated with the production of alternative fuels due to the ability to source from different input raw materials or to produce different output products based on market conditions. In this paper, we consider the particular example of ethanol and seek to quantify the incremental value from flexibility in its production from sugarcane in Brazil. We accomplish this by first jointly modeling the stochastic processes for the prices of the two relevant commodities, sugar (a food commodity) and ethanol (an energy commodity) in discrete time as a bivariate lattice. This framework allows us to value the option to switch output products based on the respective price signals of the two commodities. However, unlike the usual assumption of geometric Brownian motion stochastic processes, we use the more realistic case of mean reverting commodity price processes. We estimate the parameters for these processes by applying a regression-based procedure to empirical sugar and ethanol data collected during a period from 1998 through 2008. Our results show that the option to switch outputs has significant value, even under the assumption of mean reverting prices, which has implications for both producers and policy-makers alike.