Deriving storage value

Following an article Energy Risk published in July, TransCanada's Farzan Nathoo looks at how companies can extract value from their natural gas storage assets

Natural gas storage assets or contracts provide a series of calendar spread options to their owners. However, optimising the value of storage assets should be consistent with the risk-return appetite of the company and its approved trading strategies.

Market participants may use different strategies to extract value from the storage assets. These fall into two broad categories:

- Linear strategies: These include capturing the spreads in forward markets and re-establishing the positions on a daily basis in the forward and/or spot markets as movements in the forward and/or spot curves create opportunities for incremental value (see Energy Risk, July 2005, p84). Most market participants use this strategy to extract value.

- Non-linear strategies: Long storage positions can be viewed as long calendar spread options inheriting volatility. Hence, financial options may be used to extract the volatility value inherent in storage assets. These options can be static or dynamically managed. Some sophisticated participants may use these strategies depending on their risk-return appetite. However, appropriate skills, systems, processes and controls are necessary for the successful implementation of these strategies.

TransCanada is primarily a seller of gas storage services and products. While the company implements its own hedging programmes related to its natural gas and power businesses, those strategies may or may not include the types of strategies discussed here. Here we offer information to market participants interested in the types of futures and options strategies that buyers of storage assets can use to extract the volatility value inherent in storage assets. These strategies may require dynamic hedging.

Synthetic spread structures

The following example demonstrates a synthetic spread structure that exhibits limited downside risk. It involves:

- injecting gas in the storage facility and capturing the spread (eg, buy June 2006 and sell January 2007);

- buying far-dated call options to truncate the risk (eg, buy call options for January 2007);

- selling near-dated call options to maximise returns from the option premiums (eg, sell June 2006 call options; at expiration date, if the options expire unexercised, sell call options for the next month, and so on).

If the near-dated call options (June 2006) are exercised, the physical gas from the storage facility may be withdrawn and the loss on the near-dated call options will be offset by selling the physical gas from the storage facility. Thus, a short position will result for January 2007, backed by long call options (see figure 1).

If the near-dated call options are not exercised by expiration, the company should sell more near-dated call options for the next month. As long as the total premium received by selling near-dated call options for numerous months is greater than the total premium paid by buying far-dated call options, this strategy will generate profits.

All the near-dated call options sold must be consistent with the withdrawal constraints and all the far-dates call options purchased must be consistent with the winter gas sale commitments. Highest profit is generated when near-dated call options are settled consistently at-the-money for several months. In this regard, this structure is best for a stable price environment or where price expectations are within certain bands. This structure is also suitable for stable volatility outlook in near term (summer months) and increasing volatility outlook in over time towards the end of the storage contract year (winter months). Using options, the company establishes a short volatility position, whereas natural gas storage provides a long volatility position.

Synthetic collar-type structures

A synthetic collar-type structure is another good non-linear strategy for extracting value from storage. This involves:

- injecting gas in the storage facility;

- buying far-dated put options to truncate the downside risk on the underlying gas; and

- selling near-dated call options to maximise returns from the option premiums.

All the options must be consistent with the withdrawal constraints of the storage facility.

If the near-dated call options are exercised, the physical gas from the storage facility would be withdrawn and the loss on the near-dated call will be offset by selling the physical gas from the storage facility. To cover the demand, fuel and commodity charges, selling out-of-the-money, near-dated call options may be a safer strategy. The far-dated put options are purchased to truncate the risk on the underlying gas and hence, the underlying gas should be sold before or up to the expiry of the put options. Figure 2 demonstrates the synthetic collar-type structures.

If the call options are not exercised by expiration, the company should sell more near-dated call options. As long as the total premium received by selling near-dated call options is greater than the premium paid by buying far-dated put options and the storage facility costs (demand, fuel, commodity and interest charges), this strategy will create profits.

Straddles and/or strangles

Some trading companies, depending on their risk appetite, may decide to use some combination of a storage position, physical gas, call and put options to create straddles (same strikes) or strangles (different strikes). Other firms may use storage to hedge straddle or strangle positions. A short straddle is a sale of puts and calls, with the same strike price and expiration dates. A short strangle is a sale of puts and calls with the same expiration dates and different strike prices.

Selling strangles and/or straddles may create significant risk if the positions are only managed with static storage position. Although both straddles and strangles can be dynamically managed with the storage position to mitigate the risk, they have limited returns. Strangles have a lower risk-return profile than straddles because they involve out-of-the-money options, whereas straddles may involve at-the-money options. For example, a strangle strategy involves:

- buying and injecting gas for half the storage facility;

- selling out-of-the-money call options for half the storage facility consistent with its withdrawal constraints; and

- selling out-of-the-money put options for half the amount of the storage facility consistent with its injection constraints.

If the call options are exercised, the participant can withdraw the gas from the facility. This will create a full short gas position in the storage facility.

If the put options are exercised, then the participant can inject the gas into the storage facility. The mark-to-market loss on the underlying and potentially injected gas makes this structure extremely risky. This will also create a long position in the storage facility.

If neither of the options are exercised by expiration, the premium can be kept and another strangle can be sold for the next month.

Straddles and strangles should always be dynamically managed within the appropriate risk parameters. Both of these structures are best suited to stable price expectations and declining volatility outlook in the market.

While some storage participants use derivatives to extract value, other market participants may use storage to hedge their existing derivatives position. The greatest advantage storage offers is a series of spread options to its users.

F1. PROFIT AND LOSS PROFILE FOR SYNTHETIC SPREAD STRUCTURES

Buy summer and sell winter to capture the spread - this should cover a significant portion of demand, commodity, fuel and interest charges. A stable price environment enables the sale of more call options. Hence, the premium received from selling near-dated call options may exceed the premium paid to buy far-dated call options. Dynamic hedging may be necessary.

Source: TransCanada

- Farzan Nathoo is a quantitative specialist at Calgary-based TransCanada Corporation Email: [e-mail].