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Financial Valuation of Operational Flexibilities in the Aluminum Industry using Real Option Theory

In the aluminum industry, which is subject to a significant volatility in its output prices, as well as in the cost associated with one of its main input costs, electricity, the possibility of reducing production costs through the flexibility of the production process can generate important value for such real options. We study the effect of the flexibility available to a typical smelter (aluminum processing plant), that buys its electricity through long term contracts or alternatively owns a co-generation unit, of stopping production and selling its electricity in the spot market, when the price of its output, aluminum, generates negative or unrewarding cash flows, or when the spot price of electricity is high enough to give a higher cash flow than from its normal production process. Nevertheless stopping, and more specifically, restarting production involves costs associated with refurbishing the smelters units thermal revetment that may hamper the value of such stoppage options. This paper values such options through Monte Carlo simulation, modeling the prices of aluminum as a geometric mean reversion, and the price of electricity as a mean reversion with positive jumps. It also incorporates the asymmetrical costs of stopping and restarting production and checks its influence in the value of the option associated.