Date of Original Version



Working Paper

Rights Management

All Rights Reserved

Abstract or Description

Storage capacity for energy, such as electricity, natural gas, and oil, is limited. Thus, spot and forward purchases for delivery on the usage date play an important role in matching the supply and the uncertain demand of energy. Transaction costs tend to be larger in spot than forward energy, and more generally commodity, markets. Hence, partially procuring supply in the forward market, rather than entirely in the spot market, is a potentially valuable real option. We call this option the forward procurement option. The study of this option from the perspective of differential transaction costs has received little attention in the literature. We thus formulate and analyze a parsimonious procurement model with differential spot and forward transaction costs and correlated spot demand and nominal price random variables. Our analysis, in part based on natural gas data, sheds novel light on the value of the forward procurement option and its optimal exercise, as well as their sensitivities to parameters of interest. Our main insight is that procuring the demand forecast in the forward market is nearly optimal on the instances that we consider. This greatly simplifies the management of this option. We obtain analogous results with a richer model in which the supply procured in the forward market is delivered at multiple dates. Beyond energy, our research has potential relevance for the procurement of other commodities, such as metals and agricultural products.


Tepper Working Paper 2009-E25