Commodity Prices and the Option Value of Storage

Lewis Evans and Graeme Guthrie

Chapter 1 in Real Options in Energy and Commodity Markets, 2017, pp 3-29 from World Scientific Publishing Co. Pte. Ltd.

Abstract: Commodities are physical, not financial assets. We investigate the effects on equilibrium spot-price behavior of frictions in the storage process, which introduce an element of irreversibility to storage decisions and lead to periods when storage operators do not trade in the spot market. We value the real option to delay selling a stored commodity, which comes bundled with the stored commodity itself and generates a convenience yield. The latter arises if the spot price is incorrectly used to measure the market value of the stored commodity, ignoring the embedded real option. It can be interpreted as the expected excess return on the real option to delay selling the stored commodity. Rather than equaling a flow of benefits received during the period over which the return from storage is being calculated, it actually represents changes in the present value of benefits that will be received only some time after the measurement period, when the commodity is released from storage. Storage frictions also generate heteroskedastic spot prices, with volatility being much higher when storage operators decide not to trade in the spot market.

Keywords: Energy and Commodity Markets; Real Options; Commodity Storage and Shipping; Emission Markets; Mining Operations; Hydrocarbon Cracking Operations; Gasoline Portfolio Optimization; Market Equilibrium; Market Impact; Risk-Neutral Valuation; Financial Hedging; Stochastic Optimization; Monte Carlo Simulation (search for similar items in EconPapers)
JEL-codes: Q02 (search for similar items in EconPapers)
Date: 2017
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