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The Impact of Stochastic Extraction Cost on the Value of an Exhaustible Resource: An Application to the Alberta Oil Sands

The optimal management of a non-renewable resource extraction project is studied when input and output prices follow correlated stochastic processes. The decision problem is specified by two Bellman equations describing the project when it is currently operating or mothballed. Solutions are determined numerically using the Least Squares Monte Carlo methodology. The analysis is applied to an oil sands project which uses natural gas during extracting and upgrading. The paper takes into account the co-movement between crude oil and natural gas prices and proposes two price models: one incorporates a long-run link between the two while the other has no such link. Incorporating a long-run relationship between oil and natural gas prices has a significant effect on the value of the project and its optimal operation and reduces the sensitivity of the project to the natural gas price process.

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Energy Specializations: Energy and the Economy; Energy Modeling – Energy Data, Modeling, and Policy Analysis; Petroleum – Policy and Regulation; Petroleum – Markets and Prices for Crude Oil and Products; Petroleum – Exploration and Production

JEL Codes:
Q43 - Energy and the Macroeconomy
E61 - Policy Objectives; Policy Designs and Consistency; Policy Coordination
E60 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook: General
L13 - Oligopoly and Other Imperfect Markets
D24 - Production; Cost; Capital; Capital, Total Factor, and Multifactor Productivity; Capacity

Keywords: Non-renewable resource extraction, Oil sands, Stochastic input cost, Least squares Monte Carlo, Kalman filter, Futures prices, Real options, Co-integration of natural gas and oil prices

DOI: 10.5547/01956574.37.2.aalm

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Published in Volume 37, Number 2 of The Quarterly Journal of the IAEE's Energy Economics Education Foundation.