Computing the Value of the Real Option to Transport Natural Gas and Its Sensitivities

In the United States natural gas pipelines lease their transport capacity to shippers via contracts, which shippers manage as real options on differences between natural gas prices at different geographical locations. In practice it is common to value these real options using spread option valuation techniques, because they quickly compute both their values and, even more important, their sensitivities to parameters of interest (the greeks). Although fast, we show that in the general case of network contracts this approach is heuristic. Thus, we propose a novel and computationally efficient method that estimates the exact real option value of such a contract and computes unbiased estimates of its greeks, based on the application of linear programming, Monte Carlo simulation, and direct greek estimation techniques. We test this method on realistic instances modeled after contracts available on the Transco pipeline, using a reduced form model of the risk neutral evolution of natural gas prices calibrated on real data. Our main findings are that our method can significantly improve the practice based valuations of these contracts, by up to about 10%, and the application of direct greek estimation techniques is critical to make our method computationally efficient. Our work is relevant to natural gas shippers; a version of our model was recently implemented by a major international energy trading company. Potentially, our work has wider significance for the valuation and management of other commodity and energy real options, whose payoffs are determined by solving capacity constrained optimization models.