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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

to choose the storage hedges today, and cannot alter them in the future, the maximum value that can be locked in with certainty is the intrinsic value.

The intrinsic method has the following advantages. It is:

  • Easy to implement. Most parties can agree on what this value is.
  • A useful benchmark to gauge the valuation using any other method.

The biggest drawback of the intrinsic value method is that it fails to assign any value to storage due to price volatility. As a result, the values generated by this method are not realistic and therefore of limited significance. Despite its shortcomings, the intrinsic value is calculated as a part of any valuation process.

Spread Option Value Method

The spread option method is a natural extension to the intrinsic value method described earlier. One of the drawbacks of the intrinsic method is that it fails to assign any value to the optionality of storage. The spread option method attempts to overcome this limitation by looking at the option value of each spread rather than the static value.

In the following discussion, we illustrate some of the issues that we have to deal with when using the spread option method. The spread option matrix should be arbitrage free. It is difficult to recognize a priori whether the spread values are consistent or arbitrage-free. In other words, the spread option matrix should contain values such that the value of any basket of spreads should be equal to the value of the net spread position. When one uses a correlation matrix that is obtained using historical data, there is no guarantee that the spread option matrix being generated is arbitrage free. One needs to be very careful when using a correlation matrix for the spreads because even if it works for the volatilities obtained from the implied volatility strip for one day, there is no guarantee that it will work for another set of volatility values.

The spread option method requires a correlation matrix that is difficult to generate. What is the correlation number? Suppose the current date is June 1, 2005, and we are looking at the August 2005 to January 2006 spread. The correct number is the average price correlation between the August 2005 forward and January 2006 forward for the time period starting June 1, 2005, and ending Aug. 1, 2005. It is important to take this into consideration when determining this matrix, or ask how this matrix was generated.

In this method, the correlation does not have a term structure property. A good question to ask is the following: How are the correlation numbers generated? Most users use a 40-day price history, evaluate the logarithm of the price ratios between consecutive days to create a series of returns, and then use the pairs of time series to calculate the correlation.

But as we had described earlier, this is not what the correlation number represents. The correlation number should be the average correlation between the price returns for the two forwards that are being considered. As time elapses and one approaches the front