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The Art of Gas Storage Valuation

Benefits and drawbacks of the most popular estimation methods or modeling techniques.

Fortnightly Magazine - March 2006

When one tries to model a system, several variables can affect the system’s behavior. The modeler tries to extract a minimal subset of variables that can satisfactorily explain most of the effects under study: in this case, a natural-gas storage facility (NGSF). The question we would like to answer is: What is its value over a fixed time period?

To determine this, we must identify the attributes, or inputs, that are the key determinants of this value, and then determine how the value changes as a function of the inputs.

Before we go about trying to value natural-gas storage, we should try and come up with a list of important considerations in any valuation process. The valuation method should use:

  • Forward prices; and
  • Implied volatilities (instead of historical volatilities);

The method should be able to capture the intricacies of most NGSFs, including:

  • Injection/withdrawal ratchets: In this case, injections and withdrawals depend on inventory levels;
  • Time-based injection/withdrawal and inventory constraints;
  • Injection/withdrawal fuel factors and commodity rates; and
  • Ad Valorem taxes.

Also, the data requirements should be modest, and the calculation time should be reasonable.

The five main methods for valuing storage are:

  • Alternate Cost Method;
  • Intrinsic Value Method;
  • Spread Option Method;
  • Monte Carlo Simulation Method; and
  • Probability Tree Method.

But not all gas storage valuations are created equal, as will be explained below.

The Alternate Cost Method

This method provides a range of values to indicate what storage could or should be worth. The logic behind this method is the following: How can one replicate the services that one currently has without storage, and how much would it cost to provide such services?

For example, instead of storage, one could use long-haul transportation, coupled with an LNG peaking contract to achieve the deliverability requirements. Then one could compare the cost of these services versus the cost of purchasing storage.

The drawbacks of this method are:

  • It is hard to completely replicate the services offered by storage because storage is quite unique.
  • The valuation problem now belongs to someone else, because the entity providing the services almost certainly would have to use storage as a backstop.

Nevertheless, this method is useful because it does provide a window as to what the storage asset class should be worth relative to the alternative services available in the marketplace.

Intrinsic Value Method

The intrinsic value method is the most common method that is used to value storage and it is the benchmark upon which all other valuation is based. The idea behind the intrinsic method is simple.

Suppose we assume that the forward curve is fixed or static and we wish to determine the value of storage at the current time instant. The optimal value obtained using the static curve is the intrinsic value of storage. Another way of looking at the intrinsic value of storage is as follows: If one had

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