Case Study on Real Options

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St. Petersburg State University
Graduate School of Management
Master in Corporate Finance

Value creation at Consol Energy: a real option approach

Fedorov Roman
Lebedev Dmitry
Remezova Anna
Rusanov Valeriy
Ulyasheva Stella

Instructor: Alexandr V. Bukhvalov

St. Petersburg
2013

Table of Contents
Introduction 3
1. Company’s background and market overview 4
2.1. Energy production market in the USA4
2.2. Overview of Consol Energy Inc.5
2.3. SWOT analysis of Consol Energy 6
2.4. Uncertainties on the energy market: case of Consol Energy Inc. 7 2.5. Measurement of uncertainties of Consol Energy
2. Real options valuation of Consol Energy’s project
3.6. Formulation of the Real Option
3.7.1. Investment
3.7.2. Actions in future
3.7. Simple model of uncertainty
3.8.3. Binary tree
3.8.4. Black-Scholes Model
3.8. Real Options Analysis
3.9.5. Value of the Real Option
3.9.6. Decision making rules
3. References

Introduction

1. Company’s background and market overview
1.1 Energy production market in the USA
The United States is the second largest energy consumer in terms of total use. The majority of this energy is derived from fossil fuels: in 2012 data showed 2% of the nation's energy came from petroleum, 44.8% from coal, and 23.9% from natural gas. Nuclear power supplied 19.6% and renewable energy supplied 11.7%, which was mainly from hydroelectric dams although other renewables are included (such as wind power, geothermal and solar energy). Energy consumption has increased at a faster rate than energy production over the last fifty years (when they were roughly equal). This difference is now largely met through imports. According to the Energy Information Administration's statistics, the per-capita energy consumption in the US has been somewhat consistent from the 1970s to today. The average has been 334 million British thermal units (BTUs) per person from 1980 to 2012. One explanation suggested for this is that the energy required to produce the increase in US consumption of manufactured equipment, cars, and other goods has been shifted to other countries producing and transporting those goods to the US with a corresponding shift of green house gases and pollution. The question that may arise is how the demand for energy is going to change in the long run. For that, we can turn to a report prepared by EIA, which implies a total electricity demand growth of 28% in the projection (0.9 percent per year), from 3,839 billion kilowatthours in 2011 to 4,930 billion kilowatthours in 2040. Growth per year in absolute numbers is forecasted roughly 0.9% in a period 2011-2040, which is low comparing to 6 to 12% throughout 1950-70's. To make it more clear, refer to the graph, which visually describes this tendency.

And here comes one more issue to discuss: will the energy production market change anyhow in corresponding period? The answer is definitely positive, and the changes will be quite significant. For more evidence let's turn to another graph provided by EIA.

The graph points out several points to consider. First, coal, even with the lowest growth of all energy generating sources, will secure its place at the top with a decline from 42% share to 35%. Second, the 1.6% annual growth rate allows generation from natural gas to become more competitive with an increase from 24% share to 30%. Third, nuclear generation share also declines from 19% in 2011 to 17% in 2040. And finally, renewables make a great step forward with 1.7% annual growth, which is followed by an increase in market share from 13% to 17% in 2040. From this statistics we can conclude, that energy generation will become a more competitive industry. At the same, it will be more balanced, because the capacities will achieve better proportional distribution.

1.2 Overview of Consol Energy Inc
Consol Energy Inc....
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