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

Merchant energy trading companies manage conversion assets to exploit price differences across time, space, and sources of energy in the face of energy futures term structure risk. Financial hedging of this risk is standard practice. Market incompleteness, such as limited futures liquidity, complicates the management of this activity. We apply quadratic hedging, a pragmatic approach to mitigate financial risk when markets are incomplete, 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 cash flows across dates, establish the structure of its optimal policy, which is intractable to obtain in general, and use it to propose a novel computationally efficient heuristic. This method is provably optimal if there are only two dates or under a martingale assumption for the futures curve evolution and a simplifying restriction. Our technique performs near optimally in a realistic natural gas storage numerical study in which these conditions do not hold, outperforming a benchmark from the literature adapted to our setting that relies on the latter ones. The procedure put forth in this paper has potential applicability beyond this application