UK gas markets: The market price of risk and applications to multiple interruptible supply contracts

Abstract

We employ the Schwartz and Smith (2000) model to explore the dynamics of the UK gas markets. We discuss in detail the short-term and long-term market prices of risk borne by the market players and how deviations from expected cyclical storage affect the short-term market price of risk. Finally, we illustrate an application of the model by pricing interruptible supply contracts that are currently traded in the UK.

Predictive Performance and Bias: Evidence from Natural Gas Markets

“…Second, futures prices are biased predictors in the long-and short-run and, thus, the joint hypothesis of unbiasedness and risk neutrality has to be rejected. This finding is in line with several seminal studies ; ; Wei & Zhu (2006); Cartea & Williams (2008);Hobaeck-Haff et al (2008). Third, we highlight that past information is relevant to forecast future prices, and, thus, the information incorporated in futures contracts can be used to speculate on future spot price levels.…”

“…For HH, we see that, as the time to maturity increases, the volatility (in absolute terms) evolves rather stable whereas the mean increases. Overall, our findings for NBP are not in line with the results derived by Cartea & Williams (2008) for the UK natural gas forward market. In addition, these findings once more emphasis that futures prices are biased predictors of the future spot prices.…”

“…We expect the seasonal dummy variable to exert a positive (negative) impact on the forecast error as in autumn (winter) storage of natural gas becomes less (more) important than in other seasons. This is for example shown in Fama & French (1987) or Cartea & Williams (2008), who ascribe this finding to the existing seasonalities in production and demand (Note 37).…”

“…Furthermore, they find a significant positive risk premium inherent in UK natural gas forward markets at the National Balancing Point (NBP). The study of Cartea & Williams (2008) investigates UK forward and spot gas prices at NBP and focuses on the interdependency between risk premium and inventory levels. Cartea & Williams (2008) highlight that the short-term market price of risk is mainly determined by deviations from expected seasonal storage levels.…”

The affine styled-facts price dynamics for the natural gas: evidence from daily returns and option prices

“…However, there are many various factors affecting the price dynamics of the natural gas. Existing literatures, including Cartea and Williams (2008), Haff et al (2008), Bunn and Chen (2013), and Lin and Duan (2007), document that the price of natural gas is affected by the seasonal variation. Like the general commodity, the price of natural gas extracted is subject to the forces of demand and supply which tend to push the transaction price back to its long term average, giving it mean reversion characteristics (Schwartz 1997;Pindyck 2001;Tang 2012).…”