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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

this information in the energy markets due to the lack of liquidity. Consequently the tree parameters have to be determined from historical data.

How many factors are appropriate? The theoretical answer is, the more factors, the better the fit. Increasing the number of factors can increase only the goodness of the fit. One needs to be careful about overfitting the data.

The practical answer is, as few factors as possible. A good model should be able to capture most of the desired effects with a few factors. What the appropriate number should be is open to debate.

How does the model implement daily volatilities? If one uses the implied volatility data from a futures exchange, e.g., NYMEX in the United States, one has to examine the underlying index to see whether it is consistent with the storage market. In the United States, the underlying natural-gas futures contract is a monthly contract. Taking physical delivery under this contract implies that the underlying physical gas is delivered prorata over the course of the month. Hence the price is the average of the daily spot prices that trade for that month.

If one uses these volatility numbers to value storage, the value most likely will be understated because the implied vol-atility on the monthly index will be lower than the implied volatility on the daily prices. One would have to determine the daily volatility from the monthly number using an appropriate model.