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DEPARTMENT OF INDUSTRIAL ECONOMICS AND TECHNOLOGY MANAGEMENT VALUATION OF GAS STORAGE A REAL OPTIONS APPROACH BY BÅRD BRINGEDAL MASTER THESIS, JULY 2003 Maser Thesis, Valuaion of Gas Sorage Preface This hesis was wrien he spring erm of 2003, and is he final hesis a he Deparmen of Indusrial Economics and Technology Managemen, Secion for Managerial Economics and Operaions Research, a he Norwegian Universiy of Science and Technology. Valuaion of a naural gas sorage faciliy is a complex and exciing challenge, wih minor work previously done on he opic. I has been a grea learning experience, and I have gained valuable insigh in financial heory, and how i can be applied o analysing invesmen problems. I would like o hank my supervisor a he Deparmen of Indusrial Economics and Technology Managemen, Associae Professor Sein-Erik Fleen, for valuable and encouraging commens hroughou he process. Savanger, 9 h of July sud. ech. Bård Bringedal Deparmen of Indusrial Economics and Technology Managemen, NTNU 2003 I Maser Thesis, Valuaion of Gas Sorage Summary The main objecive of his hesis was o invesigae an invesmen opporuniy in a naural gas sorage faciliy. The valuaion mehod used was a real opions approach, which incorporaes he flexibiliy and uncerainy of he sorage faciliy operaions ino he valuaion procedure. The gas sorage faciliy analysed in his hesis was a sal cavern faciliy, also known as a high-deliverabiliy sorage. The main feaure of his ype of sorage faciliy is is abiliy o injec and wihdraw a large amoun of gas in a shor period of ime. This feaure makes i well suied o exploi changing gas prices and serve as an arbirage mechanism. The firs sep in he valuaion procedure was o deermine a sochasic spo price process o represen he evoluion of he spo price. Based on an analysis of he price dynamics for naural gas spo prices, a simple mean-revering process wih consan volailiy and mean reversion was chosen. The parameers of he sochasic process were deermined using a combinaion of an ordinary leas squares mehod and a maximum likelihood procedure. The nex sep was o value a newly insalled sorage faciliy, using he suggesed spo price process o simulae he operaion of he sorage faciliy for 15 years. In order o simulae he use of he faciliy, an opimal operaion sraegy was needed. The sraegy should be able o decide wheher i is opimal o injec gas ino sorage, wihdraw gas from sorage, or do nohing, depending on he spo price and which day of he year i is. Using a backward recursion scheme, solving for he firs order condiions of he value of gas in sorage for all sorage levels a every ime sep, he opimal sraegy was esablished. The procedure was based on a echnique called sochasic dual dynamic programming, and i solves for he marginal value of gas in sorage. Simulaed spo price pahs were used o creae a probabiliy disribuion of he spo price every day of he year. The probabiliy disribuion ogeher wih he operaional consrains of he sorage faciliy were fed ino he model o produce he opimal decision for all volume levels in sorage for all days. The value of he sorage faciliy was calculaed wih a consan volailiy and mean reversion parameers, which is a major simplificaion when considering 15 years of operaion. However, his simplificaion could be jusified if he consan level reflecs he mean value over hese 15 years. The long-erm level is difficul o predic, bu a sochasic process for his value was suggesed on he basis of he exising price daa. This sochasic process of he long-erm level should no be confused wih he daily volailiy of he spo price. The sochasic process of he long-erm level was merely a ool Deparmen of Indusrial Economics and Technology Managemen, NTNU 2003 II Maser Thesis, Valuaion of Gas Sorage needed in he valuaion of he opion o inves. I was assumed ha long-erm volailiy and meanreversion will remain reasonably close o heir presen value, and he sochasic process was chosen accordingly. When considering he opion o inves in a naural gas sorage faciliy, he opimal invesmen rule says ha if he value of he expeced cash flows from he projec less he invesmen coss is larger han he value of he opion o inves, he opion should be exercised. The value of he opion o inves in he sorage faciliy was analysed wih changing invesmen coss and uncerainy relaed o he longerm value of he volailiy and mean reversion. Differen inpu values were used o analyse he invesmen opporuniy. Wih a moderae view on he invesmen coss, he conclusion was generally ha he invesmen should be made righ away. Wih a more pessimisic esimae of he invesmen coss he opion was no exercised, bu he opion value was significan. Deparmen of Indusrial Economics and Technology Managemen, NTNU 2003 III Maser Thesis, Valuaion of Gas Sorage TABLE OF CONTENTS PREFACE...I SUMMARY... II 1 INTRODUCTION THE FINANCIAL GAS MARKET The marke place Facors ha influence gas markes Demand Compeing fuel prices Naural Gas Sorage Naural Gas Supply Marke Psychology Gas as a commodiy Delivery Convenience yield and sorage cos General price behaviour Equilibrium prices Gas Price Volailiy Mean Reversion THEORETICAL FRAMEWORK Sochasic processes The Wiener process Geomeric Brownian moion A mean-revering process Io s lemma Valuaion mehods Coningen claims analysis NATURAL GAS STORAGE Naural gas sorage ypes Need for naural gas sorage services Value componens of gas sorage Seasonal price spreads Gas price volailiy Operaional consrains Operaions coss Marke rules Oher THE SPOT PRICE PROCESS The sochasic process Daa analysis Parameer esimaion Resuls The mean reversion and volailiy parameers The yearly changes The weekly changes The resuling spo price model - example Deparmen of Indusrial Economics and Technology Managemen, NTNU Maser Thesis, Valuaion of Gas Sorage 5.5 Invesigaing he esimaed parameers Rolling window esimaion Sochasic represenaion of he Y parameer Final spo price process VALUING GAS STORAGE - THE PROCEDURE The value of gas sorage The marginal value procedure The marginal value procedure and he opimal sraegy THE MARKET VALUE OF A GAS STORAGE FACILITY Case specificaion The sorage faciliy Invesmen coss Operaion coss Marke condiions Valuaion mehod The marke value resuls A good price for gas Sorage rajecory The oal profi Marke value relaed o he Y parameer THE OPTION TO INVEST IN A GAS STORAGE FACILITY The soluion Resuls wih changing volailiy Conclusion DISCUSSION The spo price process The model The available spo price daa The valuaion mehod The opimal sraegy Operaion resricions Marke resricions Coss Invesmen coss Operaion coss Calculaion misakes FURTHER WORK AND FINAL REMARKS Furher work Final remarks REFERENCES Deparmen of Indusrial Economics and Technology Managemen, NTNU Maser Thesis, Valuaion of Gas Sorage 1 Inroducion The European gas marke has in he las decade experienced some major changes, and he demand for gas is expeced o coninue o grow he nex decades as well. The Inernaional Energy Agency (IEA 1 ) predics ha he gas marke in Europe will expand from an annual volume of 377 billion m 3 in 2000 o approximaely 620 billion m 3 by Pars of hese expanding gas supplies is desined for he residenial and indusrial secors, bu he power generaion secor is prediced o increase he demand for gas he mos. In his expanding gas marke, gas sorage faciliies will play a significan role. During periods of high demand he key requiremen is high-deliverabiliy of naural gas. This canno be achieved if he gas is supplied direcly from he producing reservoirs, as ransporaion is limied by pipeline capaciy. Sorage faciliies are he only significan supply regulaor and demand buffer, as hey are ofen siuaed close o he consumers of naural gas. Gas sorage faciliies can be used for oher purposes han securing supply in periods of high demand. Sorage faciliies wih high deliverabiliy, high injecion and wihdrawal capaciy, can quickly respond o changing gas prices, and be uilized as an arbirage mechanism. In his hesis, invesmen in a highdeliverabiliy gas sorage faciliy will be analysed. The analysis procedure can be summarized as follows SPOT PRICE PROCESS Analyze naural gas spo prices Presen a suiable sochasic process for he evoluion of naural gas spo prices Deermine he parameers of he chosen model MARKET VALUE OF GAS STORAGE Deermine an opimal operaional sraegy for he gas sorage faciliy Esablish a probabiliy disribuion of he marke value of he sorage faciliy, using Mone Carlo simulaion OPTION TO INVEST IN A GAS STORAGE FACILITY Deermine he value o inves in a naural gas sorage faciliy using a real opions approach Invesigae how differen inpu parameers affec he invesmen decision Deparmen of Indusrial Economics and Technology Managemen, NTNU Maser Thesis, Valuaion of Gas Sorage 2 The financial gas marke In his chaper he general characerisics of he naural gas spo price will be presened. Based on hese characerisics, a sochasic process describing he evoluion of he spo price will be esablished laer. 2.1 The marke place In his evaluaion of an invesmen opporuniy in a naural gas sorage faciliy, marke and price daa from he Inernaional Peroleum Exchange (IPE) in London will be used. The IPE is he second larges energy fuures exchange in he world, and has raded Naural Gas Fuures since The raded volumes have increased rapidly, and he Naural Gas Fuures are becoming a key indicaor for he UK marke. The IPE esablishes a selemen price for he delivery of gas he following day, or he following days unil he nex rading day in case of weekends and holydays, for every day of he year. Figure 2-1 shows he daily selemen prices for naural gas deliveries for he period 26. June 1998 unil 4. June Figure 2-1 Daily selemen prices June 98 June 2003 (Source: IPE) The UK marke is he mos liquid marke for naural gas in Europe, and he price daa from he IPE will be used hroughou his analysis. Alhough he raded volumes on he UK gas marke have increased seadily since 1997 (see figure 2-2), some of he informaion conained in he hisorical prices may be considered irrelevan for his analysis. As figure 2-1 shows, he spo prices he wo iniial years were almos a a consan level, somehing one would no expec o see if he marke was efficien and liquid. This will be furher commened when a sochasic spo price process will be esablished laer. Deparmen of Indusrial Economics and Technology Managemen, NTNU Maser Thesis, Valuaion of Gas Sorage Figure 2-2 Naural gas fuures raded volumes and open ineres on he IPE (Source: IPE) 2.2 Facors ha influence gas markes There are several facors ha may affec he evoluion of he spo price, and some of he mos significan will be presened in his secion Demand Economic growh From a srong economy follows a growing demand for energy. The use of naural gas in Europe in commercial and indusrial secors has grown subsanially in he las decade (figure 2-3). Also, a growing demand for elecriciy, coupled wih a desire for cleaner burning fuel and more sringen environmenal sandards, has resuled in more naural gas being used o generae power. Figure 2-3 Gas Demand in Europe (Source: BP-Saisical Review of World Energy, 2003) Weaher The mos imporan facor in deermining shor-erm price movemens is he weaher (Sailor and Muñoz, 1997). When he emperaures drop, ypically during winer, he demand for energy for Deparmen of Indusrial Economics and Technology Managemen, NTNU Maser Thesis, Valuaion of Gas Sorage heaing purposes drives he naural gas spo price upwards. The opposie effec occurs during summer. The need for heaing during summer monhs is minimal and he demand for gas is herefore low. The cyclical paern of he emperaure over he course of a year makes he naural gas spo price follow a similar paern Compeing fuel prices Fuel swiching is a emporary change from one fuel o anoher a a paricular faciliy and acs o limi gas price increases. The choice of which energy form o consume is frequenly based on relaive prices, relaive combusion efficiency, availabiliy or securiy of supply, emissions and oher consideraions. The abiliy o swich energy form is of course ofen limied due o capabiliies in he equipmen. The mos common dual-fuel combinaions are naural gas and disillae fuel oils and naural gas and residual fuel oils. Dual-fuel equipmen provides flexibiliy and promoes inegraed pricing beween fuel markes Naural Gas Sorage Underground naural gas sorage invenories provide suppliers wih means o mee cusomer requiremens during he heaing season, especially on peak demand days. The heaing season for naural gas markes is considered he five-monh period from November hrough he following March. The oher seven monhs, April hrough Ocober, become an invenory-building period called eiher he non-heaing season or refill season. In addiion o meeing winer demand loads, sorage is also used for load balancing on pipeline sysems, shor-erm parking of gas unil i is needed, and o provide a physical hedge agains price volailiy Naural Gas Supply The supply response o increased prices differs in he shor run and he long run. As demand increases and causes prices o rise, he immediae response is an aemp o provide a larger volume from he exising wells and faciliies. Companies wih spare capaciy generally respond promply o opporuniies for addiional sales. As uilizaions rise oward capaciy limis, however, furher supply increases become more difficul and cosly. When uilizaion raes approach maximum levels, supply canno adjus o increased demand and marke adjusmens primarily resul in price increases. Beyond higher uilizaion from exising wells, furher increases in supply require he drilling of new wells. However, a longer erm increase in supply requires ime for aciviies such as securing invesmen capial, acquiring land, planning drilling programs, preparing sies, hiring and raining personnel, and developing addiional infrasrucure. In oher words, here is usually a lag in ime before producion from new wells is brough onsream in response o price signals. Deparmen of Indusrial Economics and Technology Managemen, NTNU Maser Thesis, Valuaion of Gas Sorage Marke Psychology One of he facors ha can influence he price of naural gas eiher in he shor or he long-erm is he psychology of he marke in reacing o he above noed drivers (facors), including drivers such as availabiliy of pipeline ransporaion capaciy. In examining he price of naural gas and how naural gas markes are working, i is imporan ha marke psychology be aken ino consideraion. Marke psychology is very difficul o measure as i is an inerpreaion by raders and analyss of evens ha may ofen lead o a price level ha oherwise would no have been expeced. In examining he price movemens of naural gas, i is observed ha prices may a imes appear o overreac o a specific driver boh in he shor and longer erm by moving eiher higher or lower han would be expeced by he specific even (Naional Energy Board, 2002). For example, markes ha anicipae he consrucion of addiional pipeline capaciy o remove a capaciy boleneck may see he price of naural gas decline significanly prior o he acual in-service dae of he addiional pipeline capaciy. Similarly, he marke may overreac o he announcemen of a poenial severe weaher paern sending prices higher. 2.3 Gas as a commodiy When analysing he gas spo price characerisics, i is imporan o undersand he underlying conceps of gas as a commodiy. Gas is a consumpion asse, as opposed o an invesmen asse such as socks and oher financial insrumens (Hull, 2000). In his secion he main differences beween consumpion asses and invesmen asses will be highlighed Delivery Commodiies, or consumpion asses, require physical delivery. The delivery process can be boh imeconsuming and expensive. Consider buying aluminium, sugar or oil. This requires ransporaion wih boas, vehicles or pipelines, which imposes quie subsanial coss. Invesmen asses on he oher hand, have pracically zero ransporaion cos because hey are mosly paper asses. Gas is mosly disribued hrough pipelines, and pipeline capaciy may cause delivery problems and hence affec prices. The gas prices reflec he poin of delivery, i.e. prices observed in he UK marke reflecs ha physical delivery akes place wihin he UK naural gas grid a he Naional Balancing Poin (NBP) Convenience yield and sorage cos Convenience yield defines he benefis ha accrue o he holder of he asse (Hull, 2000). The benefis may include he abiliy o keep producion running when here are supply shorages, or jus benefi from he high prices when prices rise. However, he benefis of holding he asse are ofen offse from sorage coss. For commodiies such as seel, hese sorage coss are ofen subsanial. Holders of Deparmen of Indusrial Economics and Technology Managemen, NTNU Maser Thesis, Valuaion of Gas Sorage invesmen asses are neiher influenced from convenience yield nor sorage coss, and reurn requiremens are of course independen of such. Naural gas sorage The limied sorage possibiliies of gas are a significan facor when analysing naural gas spo prices. Gas is consumed a households and oher consumers spread over a large area. To preven he large seasonal changes in prices, he consumer would have o have heir own sorage uni. This would also erase weekly price flucuaions and price shocks ha occur on days of sudden large demand and low supply. However, his is no possible because of he large invesmen coss in such sorage unis. Insead, gas mus be consumed almos immediaely afer being produced. Almos because of he fac ha he pressure in pipelines can be adjused, and ha here are some large cenral sorage faciliies. However, hese adjusmen opions serve mosly o secure he disribuion, and herefore i can be saed ha gas consumpion mus equal gas producion (including shifing in sorage invenories) a all imes General price behaviour Seasonaliy Seasonaliy in he prices is observed in he spo prices due o he changing demand scenario following he weaher climae. During winer, as he emperaure drops, he demand for heaing of households causes he prices of gas o rise. During summerime, his heaing is no necessary, and he prices drop. This general observaion is observed in he hisorical prices, where he winer prices are high during winer and low during summer. In oher pars of he world, like in he souhern saes of USA, he summerime emperaures are so high ha energy is required for cooling wih air condiion. This makes he price paern exhibi wo peaks, one during winer and one during summer, wih low prices in he monhs beween. Weekly paern The demand for gas is influenced by he general work aciviy. Figure 2-4 shows he mean daily prices for gas from 1. January 2000 unil 17. March As he figure shows, during working days (Monday-Friday) he price is significanly greaer han during he weekend. The emergence of gasfired power plans has conribued o increase his effec. Gas-fired power plans are peak-demand unis and hey absorb he peak elecriciy demand generaed around mid-day during weekdays, hence increasing he gas demand in hese periods. Deparmen of Indusrial Economics and Technology Managemen, NTNU Maser Thesis, Valuaion of Gas Sorage Figure 2-4 Mean daily selemen prices Equilibrium prices Naural gas can be considered as a homogenous produc ransaced in a compeiive marke. In an efficien marke, prices will be driven o marginal cos if demand equals supply (Dixi and Pindyck, 1994). The volaile prices observed in he marke are highly correlaed wih volailiy in consumpion and producion, bu wih sorage available, marke-clearing price is deermined no only by curren producion and consumpion, bu also by changes in he sorage level. Prices will hen reflec he shorrun marginal cos of gas plus he opporuniy cos of capaciy. For naural gas, as for mos commodiies, sharp increases in price volailiy occur from ime o ime. These spikes are induced by facors such as exreme weaher condiions, disribuion problems due o emporary pipeline shudown or shorage of supply due o emporary producion shudown. These spikes are no susainable and he demand/supply revers back o normal levels wihin a shor ime. 2.4 Gas Price Volailiy The erm price volailiy is used o describe rapid flucuaions of a commodiy. In analyical erms i is known as
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