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 concerning the futures term structure affect the valuation and hedging of natural gas storage. We find that even small futures price model errors – on the order of 1-2% of the empirical 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 strategy exhibiting potentially catastrophic performance in the presence of these small errors. We propose approaches to mitigate the negative effect of 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 should have relevance for other real and financial options that depend on futures term structure dynamics, as well as inventory, production, and capacity investment policies that rely on demand forecast term structures.