Optimal Energy Procurement in Spot and Forward Markets

Spot and forward purchases for delivery on the usage date play an important role in matching the supply and the uncertain demand of energy because storage capacity for energy, such as electricity, natural gas, and oil, is limited. Transaction costs tend to be larger in spot than forward energy markets near maturity. Partially procuring supply in the forward market, rather than entirely in the spot market, is thus a potentially valuable real option, which we call the forward procurement option. We investigate the optimal value and management of this real option as well as their sensitivities to parameters of interest. Our research quantifies the value of the forward procurement option on realistic natural gas instances, also suggesting that procuring the demand forecast in the forward market is nearly optimal. This policy greatly simplifies the management of this real option without an appreciable loss of value. We provide some theoretical support for this numerical finding. Beyond energy, our research has potential relevance for the procurement of other commodities, such as metals and agricultural products.