We adapt methods, that have been empirically validated in the analysis or short-term traded securities, to evaluate long-term natural gas direct-sale contracts, We examine a sample contract from the perspective of the producer, and analyse it as a series of commodity forward and option contracts. The assessment of contract value is based on the gas price forecast, the volatility in that forecast, and the valuation of risk caused by that volatility. The method we present allows the gas producer to quantify these elements, and to evaluate the variety or terms encountered in natural gas direct-sale agreements, including features such as load factors and penalty charges. The analysis uses as inputs a probabilistic price forecast and a determination of a price of risk for gas prices. Once the forecast volatility is derived from the probabilistic forecast, the forward contracts imbedded in the long-term gas contract can be valued with a risk discounting model, and optional aspects can be evaluated using the Black-Scholes option pricing method.
Long-term gas sales agreements with "independent power producers" (IPPs) developing gas-fired power plants or cogeneration (steam and electricity) projects provide a good illustration of contract terms and evaluation problems encountered by natural gas producers IPPs will contract a 10 to 20 year gas supply using a price structure similar to that which the electrical utilities in turn offer the IPPs for power: an initial price with fixed annual escalation. In addition, volume "load factors" are incorporated in contracts to provide volume flexibility to the purchaser for shutdowns, outages, and seasonal gas demand peaks.
The problem for the producer is to determine the uncertain structure for the prices ot gas delivered over the proposed contract period, and to judge whether a proposed pricing formula and other contract features, such as volume load factors, provide adequate compensation for the long-term commitment of gas. Intuitively, producers know that the volume terms of a contract will be invoked by the buyer to his advantage, for example reducing contract lakes to minimums when spot natural gas terms are favourable. Clearly, the more volume flexibility that is in a contract, the lower the value for the producer. Unfortunately, the elect that these features have on the contract value cannot be easily determined using conventional discounting methods.
The solution to these problems lies in understanding that long-term fixed-price fixed volume sale agreements have the same essential features as a series of commodity forward contracts, and that the optional volume terms (load factors) have characteristics of commodity options. Assessment of a contract must be based on the forecast of gas prices, on the price forecast volatility, and on the valuation or the risk associated with that price forecast uncertainty. Simple discounting methods may not be useful in quantifying and valuing forward prices, and are certainly not useful in the valuations of the options, which are often imbedded in contracts. However, analytical methods, used and validated in the analysis of short-term traded stock options, may be applied to this problem