Valuation of Long-Term Flexible Gas Contracts

Many contracts in the energy markets are designed to allow flexibility of delivery. Both the timing and the amount of energy are allowed to be flexible, within certain constraints. There are many long-term contracts with such flexibility in the European natural gas market, which typically last for 10 years or more, and the volumes are large. Correct valuation of long-term contracts is important not only for pricing when entering the contract and possibly hedging, but also when renegotiations of contract parameters take place. Holden, Loland, and Lindqvist discuss the major types of flexibility and constraints related to long-term gas contracts, also known as take-or-pay contracts or swing options. By adapting the least squares Monte Carlo method, they introduce a method to price contracts that includes more flexibility constraints than previous authors have included. The authors focus on the carry-forward option, which allows flexibility between years and is considered to be the most important part of the contract not previously quantified. They show that carry-forward options give a significant increase in the value of the contract.