By: Eric Penner
A lot of natural gas storage follows a time honored pattern – put gas in during the summer and take it out during the winter. But it is getting much more complicated than that. Developments in natural gas production – particularly in the Appalachian (Marcellus) region will be driving big changes through the gas storage business. Today we pick up on a blog series we started last month to examine the two fundamental value generating gas storage mechanisms, and how they match up with the physical characteristics of storage facilities.
In Catch a Hydrocarbon, Put it in Your Cavern, Save it for a Wintry day we started this blog series by examining how storage acts as the ‘flywheel’ for the natural gas market, how much storage there is out there, where it is located, and some basics about the geology of storage. We use the term geology because almost all natural gas is stored underground, either in depleted reservoirs (old oil and gas fields), aquifers (geological structures that use underground water to trap gas), and salt caverns (huge underground caves ‘washed out’ of a salt formation with water). These different types of storage facilities are used in quite different ways to provide value to customers. And that means that there are big differences in how the various kinds of storage facilities are priced in transactions between the seller of storage services and the buyer of those services.
One more introductory comment before we get into this discussion of storage value. Who is the seller and who is the buyer? Well, it depends. Sometimes it is a utility that uses storage the old fashioned way. They store gas in the summer to meet the requirements of their residential and commercial customers in the winter. In this situation, most likely the utility both owns and uses the storage asset, so there is really no price associated with the storage capacity itself. The value of the storage is imbedded in the utility’s overall service (regulated by a state Public Utilities Commission) provided to its customers. More interesting to our discussion here is the ‘merchant’ case where a storage operator owns the storage facility and leases capacity to a company that needs the service for some business reason – perhaps to manage the gas supply for an industrial facility or power plant, or perhaps to provide a tool to be used in natural gas trading strategies. In this latter case, the operator ‘sells’ or leases its capacity to a storage customer, based on a mutually agreed price – what the customer pays the operator for capacity and the associated services (rate of injection, rate of withdrawal, length of time that the gas can be held in storage, etc.)
How Much Should Natural Gas Storage Be Worth?
As with any transaction, the fundamental question is ‘What’s the right price?’, and to that end, what basis should be used by the buyer and seller to determine the acceptability of a given price? In our personal lives, for the most part, we internalize this acceptability criteria in the sense that we develop an intuitive notion as to whether a given product (say an iphone) is subjectively more or less valuable than the asking price. In the same way, when asking how storage is priced, we must first answer the question – how much is it worth?
At the most basic level, the answer is pretty simple. The value of storage depends upon the degree to which the price of natural gas will be higher or lower at some point in the future. Unfortunately we don’t know what the future price will be (if we did, we wouldn’t be writing blogs about it). That means that a storage decision depends instead on whether there is a credible expectation that natural gas can be purchased today, stored (for the price of that storage) and the sold for a profit at some point in the future. Unfortunately accurate expectations regarding future natural gas prices rely on so many factors that it is virtually impossible for any single person or firm in isolation to determine forward prices with any degree of certainty. Thankfully though, we have a lot of help from the futures market. It might not predict what the future price will be, but it does give us a good indication of what buyers and sellers think about future prices at any point in time. In a way, looking at CME/ NYMEX forward prices makes anyone an instant (but subject to quick expiration) expert on natural gas pricing. At one level the valuation of storage boils down to simply the difference in the current spot price and the expected future spot price, the forward price.
Let’s take a moment to think about an implication of the previous statements; the value of natural gas storage relies entirely on the variation in price of natural gas over time. That means that without price variation (i.e., if price is constant), there is no inherent economic benefit to storage in our ‘merchant’ case. Of course, that is far from reality. In fact, there are two kinds of price variation which contribute to the value of storage. For reasons that we hope will become obvious we will refer to these two sources as the Signal and the Noise.
The Signal and the Noise (intrinsic versus extrinsic)
The Signal is the variation in prices caused by seasonal fluctuations in demand which rise in the winter and fall in the summer. We call it the Signal because it is a strong consistent indicator of annual price variation. This seasonal valuation, also known as the “intrinsic” value of a storage facility, is quantified by the average summer/winter forward price differential for some future period. (Note that in the gas world, the summer ‘injection’ is usually assumed to be the seven months between April-October while the winter ‘withdrawal’ season is the five months between November–March.) For example, as shown in Figure #1 below, on May 30th 2013 the average forward summer 2014 price was $4.16/MMbtu while the average forward price for the winter of 2014 - 2015 was $4.46/MMbtu. . The difference between these two prices $0.30/MMbtu indicates the intrinsic value of storage between these two time periods.
Figure #1 – Click to Enlarge
The other source of variation, the Noise, is the daily fluctuations in natural gas pricing which at times seems to have no rhyme or reason. This value, called the ‘extrinsic’ value of storage, is derived from the inherent volatility within the market. Essentially the extrinsic value comes from the same source as intrinsic value, the ability to sell gas at a higher price after some period that it is held in storage. The difference between the two is the length of time over which the price variation takes place, for intrinsic value it is long (i.e., bi-annually) and for extrinsic it is very short (i.e., one or more days). To capture the extrinsic value from these daily price fluctuations the storage facility must be able to switch from injection to withdrawal and back very quickly, often in a matter of hours to exploit the volatility. Facilities well positioned to capture this value inject (buy) gas when the price falls and withdraw (sell) when the price rises.
Quantifying the extrinsic value of storage relies on financial pricing models similar to those used to calculate the price of a financial option contract. (Business school grads might remember something called Black-Scholes, a mathematical model of option pricing.) A person can spend years attempting to understand the mathematical arguments used to justify an options pricing model (Myron Scholes won a Noble Prize for his work) but in essence it depends on a measure of the current volatility-how much the price bounces around.
Volatility in the context of natural gas prices is a measure of the dispersion of forward prices or, put simply, a measure of the distance between the maximum and minimum forward price for gas over a short time period. Obviously, as the max and min price get farther apart the value of the possibility of injecting (buying) and the min and withdrawing (selling) at the max increases.
As the level of volatility in price increases, the likelihood that large changes in natural gas price will frequently occur also increases. Capturing extrinsic value is dependent on these large price changes, so naturally as the probability of frequent large price changes increases so does the extrinsic value.
There are a number of techniques to measure historical price volatility. The most common technique starts by determining the percent change in price from one trading day to the next. The calculation then takes the standard deviation of that percent price change over some sample period of time. That value is then annualized by multiplying that standard deviation by the average number of days in a typical trading year. Don’t freak out. If you really want to understand this particular calculation see Investopedia Option Volatility: Historical Volatility. But if you just want to get the big picture, see the graphs below. Figure #2 shows a period of high natural gas price volatility back in 2009. See how much the price (the blue line) bounces around. Our measure of volatility (the orange line) ranges between 70% and 110%. That’s high. Figure #3 shows a period of low gas volatility in 2011. The price moves around very little, and our measure of volatility ranges between 30% and 40%. For natural gas that’s low. The value of extrinsic value is primarily a function of this volatility, and can be calculated using that Black- Scholes model described above. To insure our reader’s sanity, we won’t go into that math today.
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