A Real Options Analysis of Ethanol Plant Investment under Uncertainty Executive Summary

Ethanol production over the past few years has been both a haven and heartache for investors in corn-based ethanol facilities. Record-high returns in 2006 and 2007 have vanished in the face of precipitous drops in gross margins in 2008. Using a real options approach, we analyze investment and operating decisions of corn-based dry-grind ethanol facilities and identify trigger prices that signal the optimal times in which to change the status of plant operations. Specifically, we identify the levels of gross margins (price of ethanol less price of corn) that trigger firm investment and entry, suspension and reactivation of existing plants, and, finally, exit of plants from the industry. Margin triggers were estimated for three classes of plants, differentiated by plant size. Entry margin triggers drop from $1.78 to $1.33 per gallon as plants size increases, given economies of size in production. Exit margin triggers are more similar across plant sizes, ranging from $0.17 to $0.13 per gallon. In addition, firms will mothball plants when gross margins drop to around $0.17 per gallon, and later reactivate if margins increase to between $0.66 and $0.79, depending on plant size. As the variability in gross margins increase, entry and reactivation triggers increas