Merchant Commodity Storage and Term-Structure Model Error

Nicola Secomandi (), Guoming Lai (), François Margot (), Alan Scheller-Wolf () and Duane J. Seppi ()
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Nicola Secomandi: Tepper School of Business, Carnegie Mellon University, Pittsburgh, Pennsylvania 15213
Guoming Lai: McCombs School of Business, University of Texas at Austin, Austin, Texas 78712
François Margot: Tepper School of Business, Carnegie Mellon University, Pittsburgh, Pennsylvania 15213
Alan Scheller-Wolf: Tepper School of Business, Carnegie Mellon University, Pittsburgh, Pennsylvania 15213
Duane J. Seppi: Tepper School of Business, Carnegie Mellon University, Pittsburgh, Pennsylvania 15213

Manufacturing & Service Operations Management, 2015, vol. 17, issue 3, 302-320

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.

Keywords: model error; commodity and energy real options; natural gas storage; futures term structures; delta hedging and mean-variance hedging (search for similar items in EconPapers)
Date: 2015
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Citations: View citations in EconPapers (15)

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Persistent link: https://EconPapers.repec.org/RePEc:inm:ormsom:v:17:y:2015:i:3:p:302-320

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