Operating Options and Commodity Price Processes

Abstract This paper discusses the short-run dynamics of commodity prices. It deals with the interrelationships between price, inventory and price volatility as well as the effects of inventory and the producers’ operating flexibility on the dynamics of price in the short-run. It also illustrates how to model and estimate the stochastic process of commodity prices. We conclude that, in the short-run, producers’ operating flexibility reduces price volatility when the spot price is higher than the threshold price causing expansion in the scale of operations. However, we also conclude that operating flexibility can increase price volatility when the spot price is lower than the threshold price resulting in a contraction of operations. We demonstrate the failure of currently used parametric models in describing the stochastic process of commodity prices and suggest using non-parametric methods. We also recommend including the time trend in such a model. Key Words: Price, inventory, price volatility, operating options