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An Approximate Dynamic Programming Approach to Benchmark Practice-Based Heuristics for Natural Gas Storage Valuation

McCombs School of Business, University of Texas at Austin, Austin, Texas 78712
Tepper School of Business, Carnegie Mellon University, Pittsburgh, Pennsylvania 15213
Tepper School of Business, Carnegie Mellon University, Pittsburgh, Pennsylvania 15213
guoming.lai{at}mccombs.utexas.edu
fmargot{at}andrew.cmu.edu
ns7{at}andrew.cmu.edu

The valuation of the real option to store natural gas is a practically important problem that entails dynamic optimization of inventory trading decisions with capacity constraints in the face of uncertain natural gas price dynamics. Stochastic dynamic programming is a natural approach to this valuation problem, but it does not seem to be widely used in practice because it is at odds with the high-dimensional natural gas price evolution models that are widespread among traders. According to the practice-based literature, practitioners typically value natural gas storage heuristically. The effectiveness of the heuristics discussed in this literature is currently unknown because good upper bounds on the value of storage are not available. We develop a novel and tractable approximate dynamic programming method that, coupled with Monte Carlo simulation, computes lower and upper bounds on the value of storage, which we use to benchmark these heuristics on a set of realistic instances. We find that these heuristics are extremely fast to execute but significantly suboptimal compared to our upper bound, which appears to be fairly tight and much tighter than a simpler perfect information upper bound; computing our lower bound takes more time than using these heuristics, but our lower bound substantially outperforms them in terms of valuation. Moreover, with periodic reoptimizations embedded in Monte Carlo simulation, the practice-based heuristics become nearly optimal, with one exception, at the expense of higher computational effort. Our lower bound with reoptimization is also nearly optimal, but exhibits a higher computational requirement than these heuristics. Besides natural gas storage, our results are potentially relevant for the valuation of the real option to store other commodities, such as metals, oil, and petroleum products.

Subject classifications: finance; asset pricing; real options; storage valuation; dynamic programming; heuristics; Markov; upper bounds; industries; petroleum/natural gas.
History: Received September 2008; revision received May 2009; accepted July 2009.