Evaluation of Forward Sales And Options Created Through Natural Gas Storage
Authors: Salahor G.S. , Laughton D.G. 
Published: March 2010

As the North American natural gas market becomes further integrated, Canadian natural gas will increasingly be sold under contracts. with indexed, as opposed to fixed, prices. Analytical methods used in other commodity exchange markets will become useful in quantifying and managing price risk, but will require some adaptation to handle the specific transportation and marketing environment of natural gas. Seasonality of demand, and the related transportation constraints, along with the price and availability of gas storage services, will likely have some unique implications for an integrated continental market in natural gas. In such an environment, there may be occasional opportunities for producers and marketers to use gas storage and financial market instruments in price risk management or arbitrage. In this paper, we will examine expected returns from a natural gas storage/withdrawal. scheme and the implications of market volatility price of risk, the local cost of storage, and observations regarding the convenience yield (a difference between the current spot market price and futures market price for future periods). This work will include analysis of gas storage proposals of specific duration as well as evaluation of potential put options created when the storage duration is not fixed.

Introduction

Natural gas storage activity has historically been predominantly limited to large market players such as utility consumers, as a means of managing peak demand periods. However, the use of storage is becoming more common among gas producers, marketers, and consumers as facilities are being developed and utility storage services unbundled. Often the need for storage facilities is related to physical requirements driven by production and transportation constraints. However, there may be occasional opportunities to consider the use of storage in price arbitrage or as a means of managing price risk by creating physical forward sales and options. While natural gas spot prices continue to exhibit some seasonality and considerable volatility, there appear to be obvious incentives for gas sellers to consider procuring storage services. At the same time, as various continental trading hubs and price indices evolve, futures markets and various financial instruments will be used to reveal price and manage risk in the market place. It is conceivable that most gas in North America will eventually be traded in a similar manner as crude oil-with a continental index (or indices) such as NYMEX, linked to various delivery points and trading hubs throughout the continent (Morton, 1994).

The purpose of this paper is to evaluate gas storage services as a means of creating physical forward sales and options and comparing this to paper instruments which might accomplish the same. This will involve determining the value for fixed-term and optional storage scenarios and to examine the parameters (price forecast, volatility, price of risk, storage cost) which affect futures prices and the related options. The first two cases evaluated herein will examine the value of gas storage for a known duration to take advantage of an anticipated seasonal and/or secular price increase, using financial instruments (futures and options) to lock in selling prices for the stored gas.