Asset Pricing in Incomplete Markets: Valuing Gas Storage Capacity

We investigate the relationship between the gas spot market and the price of gas storage capacity.
Contrary to the common belief, the auction prices for gas storage are mostly affected by the volatility of
current market prices rather than by the winter-summer price differences. This paper provides a numerical
solution for pricing storage capacity, by taking investor’s activities through the spot market and storage
service into account. A bivariate Generalized Autoregressive Score (GAS) model is employed for modeling
the dynamics of the day-ahead and month-ahead spot market prices, as well as the time-varying volatilities
and correlations. Under an incomplete market setting, our model is able to approximate the realized auction
prices. Moreover, one interesting implication is that the implied average risk aversion of investor for a
storage contract increases with the volatility of the spot market. This is an intuitive result because storage
capacity can serve as an effective hedging product for the spot market, and the demand for this product is
high when the market becomes risky: more risk averse investors are participating in the auctions. Moreover,
a sensitivity analysis on different injection/withdrawal rates is also included, and particularly, contracts with
higher capacity rates are priced at a higher level.