Merchant Commodity Storage and Term-Structure Model Error

Abstract

Merchant operations involves valuing and hedging the cash flows of commodity- and energy-conversion assets as real options based on stochastic models that inevitably embed model error. In this paper we quantify how empirically calibrated model errors concerning the futures term structure affect the valuation and hedging of natural gas storage. We find that even small model errors—on the order of 1%–2% of the empirical futures price variance—can have a disproportionate impact on storage valuation and hedging. In particular, theoretically equivalent hedging strategies have very different sensitivities to model error, with one natural strategy exhibiting potentially catastrophic performance in the presence of small model errors. We propose effective approaches to mitigate the negative effect of futures term-structure model error on hedging, also taking into account futures contract illiquidity, and provide theoretical justification for some of these approaches. Beyond commodity storage, our analysis has relevance for other real and financial options that depend on futures term-structure dynamics, as well as for inventory, production, and capacity investment policies that rely on demand-forecast term structures.