Many energy contracts have significant optionality built into them at both the
producer and consumer ends. This can range from standard traded options to
complex embedded options in long-term contracts. Unfortunately, one of the most
complex options to price is a power station.
In the gas market, in both the USA and Europe, many of the annual or longerdated
contacts have some degree of flexibility or ‘swing’ built into them reflecting the
production flexibility and/or storage capabilities of the supplier. These allow buyers
to amend their daily or monthly takes provided they meet overall volume requirements.
This flexibility from the buyer may be offset by the ability of the seller to
interrupt the contract, for instance if there are production problems.
Such a situation leads to a complex option pricing model where it is easy to
mis-specify the parameters unless the quantitative analyst is very familiar with
the model restrictions, the nature of the pricing volatility and the contract structure.
Complex contract structures should not be finalized before these problems can be
solved.
Many sellers of such options will link the structure back to actual capabilities of
the underlying asset and given the developments of hedge accounting rules (for
instance, FASB 133 in the USA) this is likely to become more pronounced. If this is
a gas field, only limited flexibility will exist to increase or decrease production and
different storage techniques will be able to respond to market prices at different
speeds. Given these operational constraints and the sale of European- or Americanstyle
options based on single-period clearing, prices need to be handled very carefully
since the ‘real option’ may not be available or able to respond to that particular price
signal. This is particularly true when pricing against illiquid and volatile prices that
may take some time to find their equilibrium rates.
Another concern is the ability to effectively delta hedge positions given that standard
‘lot’ sizes in the power OTC markets is relatively large, transaction costs relatively
high and liquidity often sporadic. It is important to evaluate the practicality of the
delta hedging strategy in assessing the value of such a position. It is also important
to distinguish between pseudo-random and commercial optionality. Force majeure,
such as pipeline failures, can be priced like a call option but the likelihood of the call
is part random, part correlated with higher prices. This will be significantly less
expensive than commercial options that are driven purely by price. They are, however,
seldom as neutral as many like to assume, i.e. the assumption that if it was purely
random it would be costless in optionality over some time period.
Given the popularity of spreads in energy to create synthetic transport, power
stations, refineries and storage it is not surprising that spread options are also
popular. Similarly, the underlying assets need to be valued on a consistent basis
with their financial counterparts leading many (if not most) energy players to value
asset positions against their real option value.
For instance, a power station is a particularly complex ‘real’ spread option. Given
the right contract structure, it allows you to arbitrage between two energy markets,
say gas and power at a given cost. Their value will thus be driven not only by their
expected arbitrage value but also by the volatility and correlation between the
markets (high volatility/low correlation leading to high values). Some power stations
(such as a large nuclear plant) are deep in the money on the power side, increasing
their intrinsic value but reducing their option value. Others (such as an open-cycle
gas turbine which has a high energy cost, low capital cost) may be out of the money
maintaining significant option value but little intrinsic value.
The ability of a power station to take advantage of the optionality will depend on
its availability and flexibility. Power stations are not like contracts: as one electricity
executive once said, ‘contracts do not have tube leaks’. They also don’t have to obey
the laws of physics in starting up, which for some plant can take several hours or
even days. A plant that takes a long time and is expensive to start up will be
significantly less valuable from an option/arbitrage viewpoint.
Finally, some power stations can arbitrage between several markets. They may be
able to run on more than one fuel source and trade into the ‘ancillary service’16
markets.
Like many real options, these unique characteristics make it extremely difficult to
model a power station in standard models. Unless you are intent on solving the
intellectual challenge of the generalized closed-form solution for power stations I
would suggest that a Monte Carlo simulation package is a much more effective tool.
A number of companies have been developing these for years and if combined with
a quantitative understanding of the price volatility can provide an effective pricing
tool set.
It is also important to consider who will buy the option value. Many consumers of
power and gas must buy on a daily basis since they have no storage capability and
with the underlying daily volatility of these markets will be looking for firm-average
price options to hedge their physical consumption. Unfortunately this won’t match
with the production assets, leaving a complex basis position.
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