THE EVALUATION OF MULTIPLE YEAR GAS SALES AGREEMENT WITH REGIME SWITCHING

Abstract

A typical gas sales agreement (GSA), also called a gas swing contract, is an agreement between a supplier and a purchaser for the delivery of variable daily quantities of gas, between specified minimum and maximum daily limits, over a certain number of years at a specified set of contract prices. The main constraint of such an agreement that makes them difficult to value is that in each gas year there is a minimum volume of gas (termed take-or-pay or minimum bill) for which the buyer will be charged at the end of the year (or penalty date), regardless of the actual quantity of gas taken. We propose a framework for pricing such swing contracts for an underlying gas forward price curve that follows a regime switching process in order to better capture the volatility behavior in such markets. With the help of a recombining pentanomial tree, we are able to efficiently evaluate the prices of the swing contracts, find optimal daily decisions and optimal yearly use of both the make-up bank and the carry forward bank at different regimes. We also show how the change of regime will affect the decisions.