Theory of storage implications in the European natural gas market

Abstract

The theory of storage stands that futures prices should be equal to the spot price plus the interest forgone in storing the commodity and the warehousing costs minus the convenience yield on the inventory. In this paper, we test several implications of the theory of storage on the pricing of United Kingdom natural gas futures. We obtain partial evidence for the theory of storage as a complete explanation of the pricing of this futures contract. Explicitly, (i) we obtain evidence to explain convenience yield seasonality with spot price volatility, unexpected demand shocks when supply is tight, inventory variations, and trading activity in the futures markets; (ii) we obtain indirect evidence for the theory of storage in accepting the Samuelson hypothesis; (iii) weak although significant influence of storage levels in determining the basis is obtained; (iv) we find weak evidence for the inventory influence of futures volatility; and (v) finally, the slope of the convenience yield structure is found to respond to inventory changes and trading activity in the futures markets that anticipates inventory scarcity. All in all, we can conclude that our evidence for the theory of storage in this market is strong but cannot completely explain futures pricing for natural gas.