Merchant Commodity Storage and Term-Structure Model Error

Manufacturing & Service Operations Management, 17(3), 302–320

Posted: 14 Sep 2012 Last revised: 24 Aug 2015

See all articles by Nicola Secomandi

Nicola Secomandi

Carnegie Mellon University - David A. Tepper School of Business

Guoming Lai

University of Texas at Austin - Red McCombs School of Business

Francois Margot

Carnegie Mellon University - David A. Tepper School of Business

Alan Andrew Scheller-Wolf

Carnegie Mellon University

Duane J. Seppi

Carnegie Mellon University - David A. Tepper School of Business

Date Written: November 1, 2014

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 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: Commodities, real options, natural gas storage, model error, delta hedging, futures term structure

JEL Classification: G13, Q40

Suggested Citation

Secomandi, Nicola and Lai, Guoming and Margot, Francois and Scheller-Wolf, Alan Andrew and Seppi, Duane J., Merchant Commodity Storage and Term-Structure Model Error (November 1, 2014). Manufacturing & Service Operations Management, 17(3), 302–320. Available at SSRN: https://ssrn.com/abstract=2144025 or http://dx.doi.org/10.2139/ssrn.2144025

Nicola Secomandi (Contact Author)

Carnegie Mellon University - David A. Tepper School of Business ( email )

5000 Forbes Avenue
Pittsburgh, PA 15213-3890
United States

Guoming Lai

University of Texas at Austin - Red McCombs School of Business ( email )

Austin, TX 78712
United States

Francois Margot

Carnegie Mellon University - David A. Tepper School of Business ( email )

5000 Forbes Avenue
Pittsburgh, PA 15213-3890
United States

Alan Andrew Scheller-Wolf

Carnegie Mellon University ( email )

Pittsburgh, PA 15213-3890
United States

Duane J. Seppi

Carnegie Mellon University - David A. Tepper School of Business ( email )

5000 Forbes Avenue
Pittsburgh, PA 15213-3890
United States
412-268-2298 (Phone)
412-268-8896 (Fax)

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