Merchant Commodity Storage and Term-Structure Model Error

Merchants 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 about the futures price term structure affect the valuation and hedging of commodity storage assets, specifically the storage of natural gas, an important energy source. We also explore ways to mitigate the impact of these errors. Our analysis demonstrates the differential impact of term structure model error on natural gas storage valuation versus hedging. We also propose an effective approach to deal with the negative effect of such model error on factor hedging, a specific hedging approach. More generally, our work suggests managerial principles for option valuation and hedging in the presence of term structure model error. These principles should have relevance for the merchant management of other commodity conversion assets and for the management of financial options that also depend on term structure dynamics.