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The Value of Commodity Purchase Contracts With Limited Price Risk

Abstract:
This paper describes and demonstrates the equilibrium market valuation of commodity purchase contracts with price ceilings or price floors or both. These contracts, which we call "limited price risk" contracts, are significantly easier for buyers and sellers to agree upon than fixed price contracts when price uncertainty is high and buyers and sellers have inconsistent price expectations. Analysis of an actual natural gas contract as well as the existence of many brokers promoting limited price risk gas contracts, suggest that these contracts may be priced inefficiently in practice. Our example application should help managers to make use of modem financial techniques in assessing the value of these types of contracts.

Purchase ( $25 )

Energy Specializations: Energy Investment and Finance – Public and Private Risks, Risk Management

JEL Codes:
D81 - Criteria for Decision-Making under Risk and Uncertainty

Keywords: Commodity purchase contracts, Price risk, Valuation, Natural gas prices, Seasonality

DOI: 10.5547/ISSN0195-6574-EJ-Vol12-No3-8


Published in Volume 12, Number 3 of The Quarterly Journal of the IAEE's Energy Economics Education Foundation.