The Evaluation of Gas Swing Contracts with Regime Switching

Abstract

A typical 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 period at a specified set of contract prices. The main constraint of such an agreement that makes them difficult to value are that 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 period (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 and find optimal daily decisions in different regimes. We also show how the change of regime will affect the decisions.