Equilibrium and Real Options in the Ethanol Industry: Modelling and Empirical Evidence

Abstract

In the last twenty years a large number of competitive ethanol rms have estab- lished operations in the US. Ethanol, produced from corn, is blended with pure gasoline to produce fuel. Producers hold an option to turn o unpro table plants. Blenders choose to substitute ethanol for gasoline at or beyond the minimum ratio set by the government. We propose and test an equilibrium model for blenders and producers that accounts for the real optionality embedded in the industry. The model, driven by corn and gasoline prices, leads to analytical expressions for the price and physical output of ethanol, and for the value of an ethanol producer. We confront the model with data between 2000 and 2017. In line with the model, we con rm that ethanol was largely priced as the maximum of rescaled gasoline and corn prices. Historical output levels between the mandate and installed capacity were explained by the model. Finally, the share price dynamics for the largest public ethanol producer in the US was consistent in some aspects with the value of a real option.