THE VALUATION OF RESERVES OF NATURAL RESOURCES: AN OPTION PRICING APPROAC

The value of a reserve of a natural resource whose future price is uncertain is calculated by using the option pricing methodology developed in the Finance literature.;The resource is regarded as an asset which can be held short or long by investors. The reserve is seen as an option on this asset, and it is argued that owners will never want to extract their reserves if there is no time limit for extraction. This paradox is shown to be an implication of the well known result in option pricing theory which states that call options on non-dividend paying stocks are never prematurely exercised.;To resolve the paradox it is assumed that there are costs associated with holding reserves or that the extraction cost is rising with time. Analytic solutions are obtained for the valuation problem for these two cases under the assumption that the price follows a Gauss-Wiener stochastic process. The formulas obtained involve the price of the resource and its variance, the interest rate, the extraction cost and its growth rate, and the holding costs.;The case when there are storage costs for the extracted resource, in addition to the holding costs for the reserve, is discussed with the help of numerical techniques. It is seen that in this case the value of the reserve also depends on the variables listed above, in addition to the storage costs.;In all the three cases, it is shown that reserves have an option value which is defined as the difference between the value derived under uncertainty and the certainty value. This option value is generally positive, and this is shown to imply that the optimal investment in exploration under uncertainty will typically be larger than under certainty. Reserves that currently would be worthless under certainty, because their extraction cost exceeds the current resource price, are shown to have a positive value under uncertainty. This generates an incentive for exploration for these reserves.;Perhaps the most important comparative statics result is the effect of an increase in uncertainty: it increases the value of the reserve and leads to a later optimal time for extraction. Also, higher uncertainty in the price of the resource leads to a higher optimal investment in exploration.