Estimating the Strategic Value of Long-Term Forward Purchase Contracts Using Auction Models



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    • Department of Finance, Sloan School of Management, Massachusetts Institute of Technology. This research has been supported by the Center for Energy Policy Research, Energy Laboratory, MIT. I gratefully acknowledge the valuable research assistance of Guy Barudin as well as the comments of the participants at the Finance Seminars of Harvard, the University of Massachusetts, and MIT and at the meeting of the Western Finance Association and the North American meetings of the International Association of Energy Economists.


We demonstrate how an auction model can be used in a traditional capital budgeting context to assign a value to the strategic advantage of long-term forward contracts. Research in the field of industrial organization has pointed to the danger of ex post opportunistic bargaining as a motivation for the use of forward contracts in natural resources and manufactured products, but no operational procedure exists for estimating the value secured by these contracts. Arbitrage methods for valuing forward contracts assume a competitive market in which the factors creating the bargaining problem and motivating the use of long-term contracts are not present. Use of the model is illustrated in the case of take-or-pay contracts for natural gas.