Valuation of Long-Term Flexible Gas Contracts

Energy derivatives allow consumers and producers of natural gas and electricity to manage what are very complicated fluctuations in demand and supply. In particular, energy demand depends heavily on weather, which is impossible to predict accurately more than a week or two into the future. Long-term supply contracts allow some of this variability to be managed, but it is common to incorporate extensive optionality into them. Maximum and minimum values may be set for the amounts to be purchased in a given time period (day, week, month), but with options to exceed the bounds on a finite number of occasions and possible carry-forward provisions for unused options. Determining the optimal exercise strategy for these options and the appropriate valuation of the contracts that takes option exercise into account are challenging problems. In this article, the authors describe the most common optional features found in the European market for long-term natural gas contracts and offer a useful approach for valuing them, based on least squares Monte Carlo simulation.