The Value of Operational Flexibility in the Presence of Input and Output Price Uncertainties with Oil Refining Applications

Abstract

R efining is indispensable to almost every natural-resource-based commodity industry. It involves a series of complex processes that transform inputs with a wide range of quality characteristics into refined finished products sold to end markets. In this paper, we take the perspective of a profit-maximizing refiner that considers upgrading its existing simple refinery to include intermediate-conversion flexibility, i.e., the capability of converting heavy intermediate components to light ones. We present a stylized two-stage stochastic programming model of a petroleum refinery to investigate the value drivers of conversion flexibility and the impact of input and output market conditions on its economic potential. Conversion flexibility adds value to refineries by either transforming a nonprofitable situation into a profitable one (referred to as purchase benefit) or improving profitability of an already profitable situation (referred to as unit revenue benefit). In a real-data-calibrated numerical study, we find the value of conversion flexibility (VoC) to be significant, accounting for 40% of the expected profit with conversion, and the purchase benefit and unit revenue benefit are equally important. Contrary to the intuition that, as a recourse action, conversion offers higher value for greater input price volatility, we find that VoC may decrease in input price volatility as a result of the differential impacts of increasing price volatility on the purchase benefit and the unit revenue benefit. Refineries also vary in their range flexibility, i.e., the ability to accommodate a narrow or wide range of inputs of different quality levels. Whether the range flexibility increases or decreases the value of conversion flexibility is affected by the direction in which the refinery expands its processing range and the heaviness of crude oils.

Synergistic Value in Vertically Integrated Power‐to‐Gas Energy Systems

“…In these studies, the benefits of vertically integrated production systems generally stem from operational gains, while costs arise from the need for additional upfront investments in productive capacity. Recent work on vertical integration has been confined to settings where one subsystem can be added to the other, yet the added subsystem can not operate stand-alone (Boyabatli et al 2017, Dong et al 2014, Kazaz 2004. 5 Our results are also related to the real option literature which examines whether the value of a flexible system exceeds that of a rigid system sufficiently so as to justify investment in the flexible system, e.g., Kogut and Kulatilaka (1994), van Mieghem (1998), Trigeorgis (1993).…”

Managing Capital Market Frictions via Cost-Reduction Investments

“…In the operational hedging literature, riskmitigating operational decisions are explored in perfect capital markets (Table 1, bottom-left quadrant). This literature thus abstracts from the financial implications of operational hedging decisions, including a firm's ability to access capital and the resultant cost of external funds, because capital markets are assumed to be perfect (Huchzermeier and Cohen 1996, Boyabatli and Toktay 2004, Chod et al 2010, Dong et al 2014. In contrast to the literature on operational decisions in perfect capital markets (Table 1, left column), we examine the conditions under which investing in production cost reduction can create value in the presence of capital market frictions.…”

“…The right column of Table 1 shows studies that address the imperfect capital market condition, wherein operational and financial decisions are jointly considered by factoring in various capital market frictions. The top-right quadrant illustrates these decisions without considering the option of operational Rajagopalan 1998, Babich 2010, Kouvelis and Zhao 2011, Carrillo and Gaimon 2004Luo and Shang 2014, Tanrisever et al 2015, Alan and Gaur 2018, Tunca and Zhu 2018, Reindorp et al 2018, Yang and Birge 2018 Operational decisions with hedging Huchzermeier and Cohen 1996, Boyabatli and Toktay 2011, Van Mieghem 2003, Iancu et al 2016Boyabatli and Toktay 2004 (This article fits here) Weiss and Maher 2009, Chod et al 2010, Tanrisever et al 2012, Dong et al 2014 hedging. Kouvelis and Zhao (2011) explore optimal contracting for a supplier with a retailer in a newsvendor setting in the presence of bankruptcy costs.…”

Introduction to the Special Issue on Research at the Interface of Finance, Operations, and Risk Management (iFORM): Recent Contributions and Future Directions

“…For example, Boyabatlı et al (2011) considered a coproduction system with two output quality levels (boxed beef and ground beef) in a meat processing environment, and analyzed the impact of market conditions on optimal sourcing decisions. Dong et al (2014) analyzed early procurement, production, and upgrading decisions of an oil refinery facing price uncertainty in both input and output markets. They investigated two types of flexibility: range flexibility (ability to process crude oil of diverse quality) and conversion flexibility (ability to convert low quality crude to high quality crude oil).…”