Real option valuation of timber harvesting contracts

Abstract

A primary challenge for forestry businesses is valuing timber harvesting contracts. This article presents an empirical application of determining the optimal harvest volumes under stochastic prices to determine the economic value of timber harvesting contracts and manage business risk using real options theory. We illustrate a dynamic optimization solution procedure and the choice between a single long-term versus two short-term timber harvesting contracts from a risk management perspective. A case study of timber harvesting contracts sold in British Columbia is used to demonstrate specification of the many details and adaptations that are required in such valuation problems. Our article offers some interesting results. The highest timber harvesting contract values occur with optimal harvest quantities rather than an equal annual allowable cut (AAC). The difference in values can be substantial (two to three-fold). Consequently, forestry businesses can benefit by timing their harvest to nonequal quantities in later years of a timber harvesting contract. Depending on the quality of timber, the maximum stumpage value for the second short-term timber harvesting contract ranges from $12 to $17.8 per cubic meter, resulting in lower profit margins for equal AAC. In contrast, with optimal harvesting, the maximum stumpage value ranges from $2 to $8.5 per cubic meter and higher profit margins. These bounds for stumpage price and profit margins would be useful for forest businesses to better manage business risks when bidding for timber harvesting contracts.