An improved basket of spread options heuristic for merchant energy storage

ABSTRACT

Practitioners use the Basket of Spread Options (BSO) heuristic to model merchant energy storage as a portfolio of spread options and spot/forward sales. This method solves a linear program to obtain the composition of this portfolio and its associated BSO policy. Sequential reoptimization of this model yields the Rolling BSO (RBSO) policy. Although this policy performs well, typically dominating the BSO policy and often being near optimal, it can struggle when storage is fast. To attempt to obtain an improved RBSO policy, especially for fast storage, this article proposes a BSO heuristic that modifies the objective function of the BSO linear program based on exchange option prices and a tunable parameter. On a set of known natural gas storage instances, limited optimization of this adjustable quantity leads to modestly improved RBSO policies on average but substantially so when the original RBSO policies perform poorly, which occurs on some fast storage instances. Moreover, fixing this parameter to 0.6 gives RBSO policies that virtually match the performance of the best considered RBSO policies. The proposed BSO heuristic is thus as easy to use in practice as the original BSO heuristic.

KEYWORDS:

• Basket of spread options heuristic
• linear programming
• Markov decision processes
• merchant energy storage
• natural gas
• real options

Acknowledgments

The author thanks Selvaprabu Nadarajah for his help in obtaining the numerical results discussed in this article and the special issue review team whose feedback led to an improved version of this article. The author is a Faculty Affiliate of the Scott Institute for Energy Innovation at Carnegie Mellon University.

Funding

This research was supported in part by the National Science Foundation grant CMMMI 1129163.

Additional information

Notes on contributors

Nicola Secomandi

Nicola Secomandi is a Professor of Operations Management at the Tepper School of Business and Faculty Affiliate of the Scott Institute for Energy Innovation, both at Carnegie Mellon University. His research interests include energy and commodity merchant operations, trading, and real options, as well as the interface between operations and finance. He currently serves as Associate Editor for IISE Transactions, INFORMS Journal on Computing, Manufacturing & Service Operations Management and Operations Research and Senior Editor for Production and Operations Management. He is a coeditor of the special issue of Applied Mathematical Finance on Methods and Models for Energy and Commodity Markets and has edited the volume Real Options in Energy and Commodity Markets, World Scientific Now Publishers Series in Business.