Gas Storage Valuation Using a Monte Carlo Method

Storage in the energy business is a major issue. Electricity can hardly be stored at all, while crude oil is best “stored” by not pumping it out of the ground in the first place. Natural gas occupies a kind of middle position. In the natural gas market, storage facilities which permit smoothing over time of the gas they supply to the market are an important component of the supply chain. Optimal management of a storage facility entails dealing with both physical constraints and fluctuating demand. This, in turn, gives rise to contingencies that can be thought of as American options. The valuation of the facility as an investment entails solving for the expected present value of future profits, assuming optimal management. In this article, the authors show how to address this difficult valuation problem by adapting the numerical methods for pricing American options using Least Squares Monte Carlo simulation to the technology of gas storage <bold>TOPICS:</bold> <ext-link>Options</ext-link>, <ext-link>other real assets</ext-link>, <ext-link>simulations</ext-link>