Natural Gas Storage Valuation, Optimization, Market and Credit Risk Management

In this paper we present a model for the valuation, optimization, market and credit risk management of natural gas storage facilities and associated derivative contracts. A reduced form Markovian term structure model for the gas forward curve is developed and is shown to describe over 98% of the total historical variation of the fluctuations of the Henry Hub Futures curve. This approach facilitates the dimension reduction of the problem without sacrificing model realism. The pricing model also has sufficiently few parameters that their values can be implied from options price data. Moreover, the reduced form Markovian model enables the use of dynamic programming solution techniques without the need for heuristic approximations. A system of partial differential equations for the valuation and optimal strategy of the facility is derived. The resulting PDEs are solved using the method of radial basis function (RBF) collocation. When the number of injection/withdrawal opportunities is large, as in the case of high deliverability multiple cycling (HDMC) storage facilities, the RBF-PDE method can solve problems where traditional heuristic approaches may be impractical. In addition, as a by-product of the RBF-PDE solution process a series of analytic RBF expansions for the value of the gas storage contract at every time-step is produced. These RBF expansions can be differentiated analytically to obtain the relevant hedging statistics and because they can be evaluated in a matter of milliseconds, they can facilitate the easy calculation of the counter-party credit exposure profiles. Such profiles are required to price and manage counterparty credit risk and for calculating the economic and regulatory capital requirements for financial institutions that trade storage derivatives.