Estimating the Cost of Switching Rights on Natural Gas Pipelines*

Abstract

This paper is about the. pricing of contingent services. The immediate problem is this: What is the cost of the right to choose among pipeline and spot market purchases of natural gas? Changes in the regulation of natural gas pipelines created these rights for customers without providing a mechanism for compensating pipelines. Recently the Federal Energy Regulatory Commission recognized this oversight and called for the rights and obligations of pipelines and customers to be stated explicitly in pipeline service agreements. In the future, service agreements that provide switching rights will be sold at a premium to those that do not. This paper shows how techniques of option pricing can be used to estimate the cost of switching rights. The cost depends on the spot and forward prices of gas, the volatility of gas prices, the rate of interest, and any fees or other restrictions on switching. The option pricing framework should prove useful for pricing contingent services in other sectors of the energy industry as well.

Keywords

Natural gas Pipelines Switching rights Option pricing

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