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Cointegration and Hedging in the US Natural Gas Market, 2016, (Under Review)

Chain of Cointegration in the Refined Products Market, 2016, (Under Review)

Commodity Beta Can be Between Zero and Infinity, 2016, (Under Review)

Maturity Structure of Commodity Roll Strategies , 2016, (Under Review)

Abstract: We investigate the maturity-structure of roll strategy returns in the energy futures markets. Our innovation is to report and analyze the risk/return profile, the Sharpe ratio, and the asset pricing loadings of rollover strategies based on futures contracts of the same underlying commodity but with maturities between two and 12 months. We find that a conditional rollover strategy, which takes a long position in backwardation and a short position in contango, delivers the highest Sharpe ratio for all commodities. While we don’t observe a significant difference in terms of asset pricing beta for different roll positions, the Sharpe ratio tends to be higher for contracts with a shorter time to maturity. We also report some distinct patterns of maturity-structure across energy commodities. Findings of the paper have implications for managing commodity-based investments.

Blending under Uncertainty: The Option Value of Biofuels Mandates (R&R)

Abstract: This paper studies the dynamics of the value for a representative ethanol producer that benefits from both low and high gasoline prices is modeled. Ethanol producers make a modest competitive profit in the mandate-induced region of production. A low price of gasoline increases the demand for blend ethanol and consequently increases the profit of ethanol producers. On the other hand, when gasoline becomes costlier than ethanol, the capacity constraints of the biofuels sector bind and ethanol producers gain large quasi-monopoly margins. This is an interesting example of a market where two commodities are complement up to a point and then substitute after that. We postulate the value of an ethanol producer as a strangle option consisting of two real options: the option to substitute gasoline at times of expensive crude oil and the option to expand supply of blend at times of cheap gasoline. Using a dynamic model we show that the higher volatilities of crude oil and ethanol costs increase biofuels firms’ value. We also find non-monotonic relationships between the value of an ethanol plant and several underlying variables, including gasoline price level. We estimate the value provided by a 10% blend mandate to be around $150,000,000 for a representative ethanol unit. Our results offer a novel view of oil and feedstock price risks in contrast to the common belief that considers those risks as a negative factor for the biofuels sector.

Islamic Finance and the Energy Sector

Abstract: Islamic finance has been a growing sector in the resource-rich region of Middle East. This paper analyzes existing experiences with Islamic financing of energy projects. We argue that Islamic finance provides an additional channel to attract financial resources to improve energy efficiency, access to energy, and a sustainable energy supply. Major forms of Islamic finance methods used in the energy sector (including gas, petrochemical, and power projects) are reviewed based on real-world cases. A review of the limitations of Islamic finance in the energy sector and a set of policy recommendations are offered.

Biofuels Producers in a Deregulated Market, 2015, Under Review

Abstract:In the deregulated fuels market, biofuels and fossil fuels are close competitors and substitutes. Thus, biofuel producers are subject to risks due to volatile crude oil and biofuels feedstock prices. This paper proposes a two-sector fuel market with competing oil refinery and biofuel sectors, calibrated for cases of gasoline/ethanol and diesel/biodiesel. The model suggests that ethanol and biodiesel plants will shut-down approximately 40% and 20% of the time, respectively. The skewness of profits is -0.32, in contrast to the 0.91 of feedstock prices. Several firm-level and policy-level options to manage crude oil price risks for biofuel producers are discussed further.

Jean Tirole’s Enduring Influence on Energy Policy Analysis, with Ali Dadpay, 2014

Abstract:Jean Tirole, the recipient of the 2014 Nobel Prize in Economics, has made lasting contributions to many fields of economic analysis and policy. The present paper highlights the most important components of his contributions and their impact on developing new frontiers in energy policy analysis. We review the implications of his research in areas such as utilities regulation, environmental regulation and climate change, entry to upstream markets and energy markets, as well as the process of financing new energy projects. The paper ends by commenting on the impact of his recognition by the Nobel Prize Committee and how the future will not be the same.

Biofuels Supply Risks and Price Volatility, with Jessika Trancik and Mandira Roy, 2014

Abstract:Biofuels have been evaluated based on their greenhouse gas emissions, costs, and potential scale of production. Here we propose that feedstock supply risks should be added to the list of key metrics for evaluating the performance and scalability potential of transportation biofuels. Biofuels rely on agricultural production as their primary input, which is subject to yield shocks. A risky feedstock supply in conjunction with a highly inelastic demand for transportation fuels can cause substantial fuel price fluctuations, cost volatility, and quantitative shortages if left unmanaged, which could negatively impact biofuels firms, consumers, and society, particularly as biofuels grow to meet policy mandates. We show that the historical yields and prices of major crops used as feedstock are volatile, with a volatility roughly comparable to that of crude oil. We outline the determinants of biofuels supply risks, and discuss how the magnitude of these risks may change with production scale and technological specifications. Finally, we discuss various policy-level and firm-level strategies for reducing the supply risks of biofuels, including geographical and crop diversification. Our analysis focuses on biofuels, but the general framework could be applied to analyze the expected price volatility and scalability potential of other technologies as well.

Endogenous Entry, Long-Run Risks, and Asset Prices, 2012

Abstract:This paper explores the effect of entry dynamics on equilibrium asset prices. Using a multi-sector stochastic general equilibrium (DSGE) model I show that following a productivity shock, the total dividends of low barrier-to-entry industries rise, through the entry of new firms, but per-firm dividends revert back to a steady-state level, after a temporary increase. As a result, the cash ow of firms in low entry barrier industries has a low correlation with aggregate consumption over long horizons. On the other hand, firms in industries with high barriers- to-entry benefit from persistent shocks to long-run productivity, causing their value to co-move more strongly with shocks to long-run consumption. My analysis suggests that the loading of equity returns on the long-run risk factor (a la Bansal and Yaron (2004)) is stronger for high barrier-to-entry industries, implying that portfolios long in high barrier-to-entry industries and short in low barrier-to-entry industries should mimic the long-run risk factor.

Can Long-run Risks Explain Commodity Excess Risk Premium Puzzle?, 2011

Abstract:I develop a production-based asset-pricing model which elaborates the interaction between long-run consumption risks (a la Bansal and Yaron (2004)) and commodity price dynamics. Using this model, I propose a new interpretation to the observed volatility and excess returns of commodity futures. The model suggests that the instantaneous supply (and consequently, the spot price) of an exhaustible/storable commodity is sensitive to long-run trends, even in the absence of changes in the short-term demand. My structural model elaborates “storability” as a major factor determining “consumption” and “wealth” betas. The model not only introduces a new risk factor (emerging from shocks to wealth) but also predicts a state-dependent risk-premium for commodity futures. These features generate a rich dynamics of investment behavior and equilibrium price formation that can induce forward curves both in contango and backwardation. I simulate my model using standard parameter values and show that the risk-premium through this channel can be significant. Finally, using proxies for long-run risks and forward-looking returns, I show that a correct specification of a utility-based asset pricing model (by including hedging portfolio effect) can explain commodity returns.

Transmission of Risk in a Supply Chain, 2011, Working Paper, Co-authored by Sheridan Titman and Stathis Tompaidis (both from UT Austin)

Abstract:We present an equilibrium model of price dynamics and the transmission of shocks in a supply chain. Starting with exogenous processes for the net supply of the upstream input and the demand for the downstream output, we construct the equilibrium process for the input and output prices, the spread between input and output prices, and the value of the capital asset that transforms the input into the output. We specify and calibrate our model for the case of the crude oil and gasoline in the context of oil refineries and estimate the structural parameters. Moreover, we provide comparative statistics from our model and empirical evidence supporting the predictions.

Structural Model of Commodity Price Dynamics, 2011

Abstract:This paper contributes to the theory of exhaustible resources as well as commodity price dynamics by characterizing a problem of simultaneous optimal extraction and dynamic capacity building. I assume a random demand process and an infinite set of options to increase maximum ex-traction rate through irreversible investments. It is shown that previous results which suggest that extraction capacity should be built at the initial periods, are not necessarily true under uncertainty. The model characterizes the optimal path of capacity investments and suggests a possible solution for the old puzzle of why the predictions of Hotelling model are not observed in reality. Using Monte Carlo simulation, the model generates term-structure of commodity forward price and volatility. The qualitative behavior of price path is close to what observed in reality The results of this paper can contribute to better understanding of long-run energy and commodity supply elasticity and price dynamics.

Migration Options for Skilled Labor and Optimal Investment in Human Capital, with Baran Siyahhan, 2010

Abstract:This paper develops a model of optimal education choice of an agent who has an option to emigrate. Using a real options framework, we analyze the time evolution of human capital in the home country and investigate the role of migration opportunities in the accumulation of different types of human capital. The analysis shows that the accumulation of human capital depends crucially on the level of uncertainty and the transferability of human capital across countries. Government subsidies are an important determinant of the composition of different types of human capital and can be crucial in alleviating the brain drain problem.

Spreads and Capacity Utilization in the US Refinery Industry

Critical Review of Virtual Water

Option Value of Mortgage Tax Deductibility

Google Searches and Energy Price Volatility

Optimal Design of a Cancer Research Fund