Contingent claims analysis of optimal investment decision making in the management of timber stands

The treatment of timber stand investment problems involving stochastic market prices for timber and multiple options can be considerably improved by the application of real options analysis. The analysis is applied to the dilemma of mature slash pine pulpwood crop holders in Florida facing depressed markets for their product. Using a contingent claims approach an arbitrage free market enforced value is put on the option of waiting with or without commercial thinning, which when compared with the present market value of stumpage allows an optimal decision to be taken.; Results for two competing models of timber price process support the decision to wait for a representative unthinned 20-year-old cutover slash pine pulpwood stand with site index 60 (age 25) and initial planting density 800 trees per acre. The present (III Qtr 2005) value of stumpage is {dollar}567/acre as compared to the calculated option value for the Geometric Brownian motion price process of {dollar}966/acre and {dollar}1,290/acre for the Mean Reverting price process. When the analysis differentiates the merchantable timber yield between products pulpwood and chip-n-saw with correlated Geometric Brownian motion price processes the option value rises to {dollar}1,325/acre for a stumpage market value of {dollar}585/acre. On the other hand the commercial thinning option holds no value to the single product stand investment when the poor response of the slash pine species to late rotation thinning is accounted for.; The analysis shows that the measurement of option values embedded in the timber stand asset is hampered by the lack of availability of market information. The absence of a market for the significant catastrophic risk associated with the asset as well other non-marketed risks also hampers the measurement of option values.; The analysis highlights the importance of access to market information for optimal investment decision making for timber stand management. It concludes that stand owners can realize the full value of the significant managerial flexibility in their stands only when access to market information improves and markets for trading in risks develop for the timber stand investment.