Energy Power Risk Management Journal: to Store or not to Store?

1 October 2003

Natural Gas: To store or not to store?

That’s the question. Energy Power Risk Management (now Energy Risk) published the following article in October 2003. It describes the optimal operation and valuation of natural gas storage based on a real option methodology. Cyriel de Jong and Kasper Walet clarify the optionality in gas storage, analyse its valuation and discuss hedging strategies to secure part of the storage value. They use Zeebrugge gas prices as a practical example.

Storage plays an increasingly important role in matching supply with demand in natural gas markets. However, companies waste significant storage value, if optimal investment and operational decisions are solely based on the seasonality pattern in gas prices. Daily volatility creates significant additional value. Storage facility owners can reap this value using a recently developed real option technique.

The Role of Storage

As mentioned, storage plays a vital role in natural gas markets. Why? Because the average variability in the consumption of natural gas is much greater than the average variability in production. Historically, natural gas storage was used for two main functions. First, it provides local distribution companies with adequate supply during periods of heavy demand. This is done by supplementing pipeline capacity and serving as back-up supply in case of an interruption in wellhead production. Second, storage enables greater system efficiency. Instead of satisfying winter demand by adding new production facilities, the industry can maintain production at a much more constant level throughout the year.

In the liberalisation process, the natural gas storage service is unbundled from the sales and transportation services. This means that storage is offered as a distinct, separately charged service. Combined with the development of active spot and futures markets, it becomes possible to adjust trading decisions to price conditions. In other words, buyers and sellers of natural gas can use storage capacity to take advantage of the volatility in prices.

Conclusion

Storage facilities will play an increasingly important role in liberalised natural gas markets in matching time-varying demand to supply. For optimal investment decisions, we must accurately determine the value of storage. We need to take into account both the intrinsic value (due to seasonality) and the option or flexibility value (due to volatility). Accurate valuation based on the flexible least-squares Monte Carlo approach may reduce investment uncertainty. Such increased certainty, combined with the substantial real option value – as we might find find in a Zeebrugge storage facility – may trigger even more investments in this area.

To view the full article, please click here: EPRM gas Storage

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