A theory of natural gas contracting, and a contingent claim method of evaluating natural gas purchase volume options

This dissertation presents a theory of natural gas contracting, and a numerical method to evaluate contingent claims with multiple interrelated exercise decisions over time. This dissertation hypothesizes that large appropriate quasi-rents associated with geographically fixed investments lead to extensive contracting in the natural gas industry. Transportation contracts exist to reduce transactions costs associated with ex post bargaining over appropriable quasi-rents. When the logistics of a transaction precludes delivery at an active spot market, a transportation contract alone is unlikely to be the low cost solution. A sales contract is likely to reduce transactions cost further. Use of a sales contract also may be motivated strictly by a desire to hedge price risk. In either case, a purchase volume option will be included in a sales contract when the customer's demand is uncertain. A purchase volume option serves to reduce transactions cost associated with ex post bargaining, or to improve the hedge. Purchase volume options are a low cost solution because natural gas is expensive to store after it is produced. Purchase volume options in natural gas sales contracts often take the form of take-or-pay provisions.; This dissertation also presents a technique to value contingent claims with multiple interrelated exercise decision over time. The contingent claims evaluated are natural gas sales contracts with take-or-pay provisions. The numerical valuation technique presented is general and likely to be applicable to other contracts, as well as to other capital budgeting problems. This valuation technique involves dynamic programming within a lattice. Equations are brought back across the lattice and adjusted for optimal exercise decision rules at each exercise date. These equations represent the value of the contingent claim as a function of path dependent parameters that are affected by earlier exercise decisions. Comparative statics are generated and tested.