Conditional Quadratic Hedging of Futures Term Structure Risk in Merchant Energy Trading Operations.

Click HERE to join the seminar online via Zoom.

Merchant energy trading companies manage conversion assets to create value by exploiting price differences across time, space, and sources of energy in the face of energy futures term structure risk.  Financial hedging of this risk to preserve this value is standard practice.  Market incompleteness, such as limited futures liquidity, complicates the management of this activity.  We apply conditional quadratic hedging, a pragmatic approach to mitigate financial risk, to the management of term structure risk in real option models of merchant energy trading operations.  We develop a model that, in contrast to known applications of this methodology, pools operating cash flows across dates and stops financial trading when these cash flows do too, establish the structure of its optimal policy, which is intractable to obtain in general, and use it to propose two novel computationally efficient heuristics. One of them is provably optimal in a fairly general setting, whereas the other one is so in more restrictive contexts. Our work to date shows that the latter heuristic performs near optimally in a realistic long duration energy storage numerical study, outperforming a benchmark from the literature adapted to our setting.  The approach put forth in this paper is relevant for what is known as perfect hedging in practice, potentially beyond this application.