In his article ”Gas Storage Valuation in Incomplete Markets”, LCL Professor Nils Löhndorf and co-author Professor David Wozabal from Technische Universität München investigate the problem of pricing and operating natural gas storage facilities when markets are incomplete.
They argue that the complete market assumption is not tenable for valuation of gas storage facilities, because the value an individual agent ascribes to storage depends on individual expectations of future price dynamics, specific institutional, and organizational constraints, as well as individual risk aversion regarding possible future cash flows.
The two researchers show that rolling intrinsic valuation, which is popular among energy merchants, is an inconsistent pricing rule when markets are incomplete, and propose an exact valuation approach based on indifference pricing.
As the underlying stochastic-dynamic optimization problem is computationally intractable, they develop a tailored approximation algorithm and demonstrate its effectiveness based on a stochastic model of NYMEX Henry Hub natural gas futures.
The results inform managerial decisions on risk management and asset pricing for natural gas highlighting the importance of explicitly modeling risk preferences.