Valuation of Swing Contracts by

Least-Squares Monte Carlo Simulation

Bart J.A. Willigers, SPE, Palantir Economic Solutions, Steve H. Begg, SPE, University of Adelaide,
and Reidar Bratvold, SPE, University of Stavanger

Summary development (sizing, sparing, and sequence of bringing reserves on

Natural gas and electricity are commonly traded through swing line) that will be needed to deliver the contracted quantities.
contracts that enable the buyer to exploit changes in market price The buyer (contract holder) should aim to negotiate, and be
or market demand by varying the quantity they receive from the willing to pay for, contract terms that will best account for the
producer (seller). The producer is assured of selling a minimum uncertainties that matter to them—for example, demand or price.
quantity at a fixed price, but must be able to meet the variable To both parties, the value of swing contracts, or swing options,
demand from the buyer. The flexibility of such contracts enables is dependent on the variability, from period to period, in the uncer-
both parties to mitigate the risks and exploit the opportunities that tain quantities (e.g., production, demand, and price) that the terms
arise from uncertainty in production, demand, price, and so on. But of the contract are designed to address. Traditional NPV calcula-
how valuable are they? Traditional net present value (NPV), based tions replace the real variability of these uncertain quantities by
on expected values, cannot value this flexibility, and the traditional their expected (average) values. Therefore, by definition, NPV is
options/valuation techniques could not model the complexity of the unable to assess the value of any flexibility (provided by options)
terms of such contracts. that is designed to respond to that variability.
Taking gas contracts as an example, this paper seeks to (a) raise During the 1970s, new methods (Black and Scholes 1973; Mer-
awareness of how flexibility creates value for both parties and (b) ton 1976) were developed to correctly value the option (that is, the
show how least-squares Monte Carlo (LSM) simulation can be right, but not the obligation) to trade financial instruments (e.g.,
used to quantify its value in dollar terms, from the perspective of stocks) and commodities (e.g., pork bellies and grains). These trad-
both producer and buyer. Because the value of flexibility arises ing options are known as derivatives because they are derived from
from the ability it gives to respond to fluctuations (e.g., in com- underlying tangible assets whose future price is uncertain. Trading
modity prices), a useful model of swing contracts needs to reflect of these derivatives has grown over the past 3 decades, and the
the nature of these fluctuations. techniques for valuing them have matured and been validated in the
markets. However, the oil and gas industry has seldom addressed
Introduction its potential in upstream decision making. Stibolt (1996), in a study
Natural gas and electricity are commonly traded on swing or called “Improving management of oil and gas assets through deriva-
take-or-pay (ToP) contracts. Swing contracts permit the buyer of tives,” stated: “Examples [of derivatives] that cannot be ignored
the commodity (the contract holder) to periodically exercise the include swing options that producers give away at no charge.”
option (the swing option) to vary the quantity purchased within a There are two significant challenges in valuing swing options.
specified range, subject to purchasing an agreed minimum quan- First, because the value of a swing contract arises from the flex-
tity in a specified period. The holder is thereby able to manage ibility it offers to react to fluctuations in uncertain quantities, a key
uncertainties in end-user market price or market demand because requirement in valuing that flexibility is to be able to model the
of seasonality or other factors. The other party to the contract, the characteristics of the fluctuations. Second, the value can be realized
producer (or seller), is obliged to supply the quantity demanded only by developing a strategy that ensures the best possible tim-
by the buyer. Although swing contracts in the exploration and ing at which to exercise the options that have been granted in the
production industry are generally made between producers and contract. Although an option might have positive value, the holder
buyers, the selling party could in principle also be a nonproduc- might decide not to exercise it, if they expect more-favorable future
ing supplier. The seller benefits by being assured of a minimum pricing.
purchase quantity and specified price over the contract period, In this paper, the LSM simulation methodology (Jacques 1996;
thereby reducing economic risk associated with developing costly Longstaff and Schwartz 2001) has been applied to quantify the
production facilities. value of a swing contract for both the buyer and the seller of the
The widespread use of swing contracts suggests that gas trad- gas. A mean-reverting stochastic process is used to model price
ers intuitively understand that there is inherent value in flexibility. fluctuations, and a strategy map has been developed to define what
Two important questions arise for the buyer: What is the value of market conditions justify the exercise of a swing option. Before
the flexibility in the contract terms, and when should they exercise moving on to the objectives and details of the case study, the
their option? The key question for the seller: What facilities should following four sections provide further background on three key
they build to manage the uncertainty in their ability to produce the aspects of the work: the nature of swing contracts, valuing con-
commodity and the uncertainty in demand from the buyer? tracts that have swing options, and the use of stochastic processes
From the perspective of exploration and production profes- to model the temporal dynamics of prices.
sional, their inability or failure to value flexibility appropriately Study Objectives
can have two negative consequences. First, they risk transferring
Although swing contracts have been traded in the energy industry
unnecessarily high value to the owners of the swing contract with-
for numerous years, methods to accurately value these instruments
out realizing it. That is, the producer will not gain the full remu-
were not developed until the last decade. Published models typi-
neration they could, given the terms of the contract. Second, the
cally assessed the value of swing contracts from the perspective of
producer may formulate a substantially suboptimal design for the
the buyer of gas. This study aims to provide insight on the value
of the swing contract for both the gas seller and the gas buyer.
Copyright © 2011 Society of Petroleum Engineers We refer to the party that buys the gas on the swing contract as
This paper was accepted for presentation at the 2010 Asia Pacific Oil & Gas Conference the “trader” and the party that sells the gas on the contract as
and Exhibition held in Brisbane, Queensland, Australia, 18–20 October 2010, and revised the “producer.” We have developed a comprehensive model that
for publication. Original manuscript received for review 2 December 2010. Revised paper
received for review 2 August 2011. Paper peer approved 15 September 2011 as SPE paper
incorporates several operational considerations in the valuation of
133044. a gas swing contract.

October 2011 SPE Economics & Management 215

 We expect that poor understanding of stochastic price model- gas stream between the gas producer and the owner of a swing
ing is largely responsible for the lack of acceptance of real option contract.
valuation within the exploration and production decision-making
community. Accurate valuation of swing contracts is challenging Valuing Contracts With Swing Options
and clearly requires stochastic price processes. The model devel- The flexibility that is associated with a swing contract can be
oped in this study demonstrates how this can be achieved. shown to account for a substantial part of its total value. Value
is created when the owner of the contract has the possibility,
Swing Contracts at a future date, to react and make an optimal decision once an
uncertainty is resolved. Because Myers (1977) coined the term
A swing contract contains options that give its owner the right to
“real options” after recognizing such option-like characteristics
buy additional volumes of a commodity over the duration of the
for numerous real investments, the valuation of flexibility associ-
contract. In this paper, we refer to these options as “swings.” A
ated with exploration and production assets has been extensively
typical swing contract guarantees the periodic delivery of a speci-
discussed in the literature.
fied amount of commodity on given dates in the future, within a
Value of flexibility arises only when the economic value of
given delivery period (Barbieri and Garman 2002). The commod-
an asset is uncertain. Generally, the greater the uncertainty, the
ity is traded at a stipulated constant price, referred to as the strike
greater the value of flexibility. A practical distinction can be made
price. Numerous swing contracts constrain the minimum and
between private and public uncertainties (Smith and Nau 1995;
maximum amounts to be delivered at each trading period and a
Cortazar et al. 2001). Private uncertainties are project-specific and
maximum allowable difference in delivered amount in consecutive
do not correlate with uncertain market conditions. Reservoir-rock
periods. Some swing contracts define a floor and a ceiling for the
quality, the reserves in place, and the strength of aquifer drive
total volume of commodity traded in the contract. Other contracts
are private uncertainties, whereas oil prices, steel prices, and rig-
divide the contract period into subperiods and, rather than a single
rental rates are public uncertainties. The value of flexibility to
trading price, have a series of prices that are established at the
respond to private uncertainties can relatively easily be quantified
start of each subperiod (Barbieri and Garman 2002). Penalties
by using subjective probability assessments with decision trees.
typically apply when the conditions as defined in the contract are
As a consequence, the value of flexibility associated with private
not fulfilled.
uncertainties is routinely assessed in exploration and production
Swing contracts enable the holder to decide the timing of
economic evaluations. In contrast, the value of flexibility related to
delivery within the duration of the contract and are therefore used
public uncertainties is rarely captured in exploration and produc-
to reduce adverse impacts of fluctuations in demand and price of
tion project economics.
commodities. These contracts are especially useful if the traded
Luehrman (2001) investigated mainstream decision makers’
commodities are difficult or expensive to store. Swing contracts
lack of acceptance of valuing real options that include public
are used in the trading of electricity (Keppo 2004), coal (Joskow
uncertainties. He identified three main obstacles: (1) marketing
1985, 1987), and gas (Strickland and Clewlow 2000) and are
problem, (2) analysis problem, and (3) impact problem. The mar-
alternatively known as ToP contracts or variable base-load factor
keting problem refers to the suboptimal distribution of knowledge
contracts (Kaminski et al. 2004).
and the lack of support for real option valuation within the organi-
The following are the key terms in gas contracts, which typi-
zation. The analysis problem refers to the difficulty in creating the
cally extend for 20+ years:
technical skills required for real option valuation. The final issue,
• Annual contract quantity (ACQ): the maximum annual quan-
the impact problem, refers to the reluctance of decision makers
tity that the buyer can request and the producer (seller) is obliged
to apply real option valuation results. Luehrman (2001) identified
to deliver. Some contracts permit the buyer to change their ACQ
the impact problem as the most difficult of the three issues and
in future years. Several other key contractual terms are derived
recognized that this cannot be resolved by either dedicated special-
from the ACQ.
ists or formal training.
• Daily contract quantity (DCQ): ACQ/365; that is, the constant
daily amount that is equivalent to the ACQ.
• Maximum daily quantity (MDQ): the daily upper limit to The Necessity for Stochastic Price Processes
which the buyer is entitled, and which the producer must be able Since Luehrman published his paper, several studies (e.g., Bratvold
to deliver. et al. 2005; Yao et al. 2006; Willigers and Hansen 2008) intended to
• The MDQ/DCQ ratio indicates the flexibility given to the explain the complex theoretical basis underlying real option valua-
buyer to manage uncertainty. For this reason, it is often called a tion in layman’s terms and to discuss the implications of different
“load factor.” Different types of buyers will require different load real option valuation methodologies. These studies devoted sparse
factors (e.g., gas retailers vs. industrial manufacturers) and there- attention to the hurdle of creating management support for model-
fore will value them differently. The ratio will impact the design ing the variability and uncertainty in future prices. Models that are
(and therefore cost) of the seller’s production facilities, which must able to do this are termed stochastic price processes or probabilistic
be able to produce at the MDQ. price models (probability being how we quantify uncertainty).
• Annual minimum quantity (AMQ): the minimum yearly The application of a time series of fixed or smoothly increasing
quantity the buyer is required to take or to pay for and (under hydrocarbon prices and costs is deeply engrained in the processes
certain conditions) receive the balance of in a subsequent year. used by the exploration and production industry in its economic
This provides an assured income for the producer. The AMQ is analysis. These hydrocarbon prices are sometimes referred to as
usually specified as a percentage of the ACQ, and is alternatively “corporate planning prices” or “price decks” and tend to be more
called ToP. conservative than the current spot or future prices. The argument
• Price and escalation: An agreed price for the gas is specified often used for choosing conservative planning prices is that “we
in advance for each year, escalating as a function of the consumer want to ensure that our projects are robust enough to be profitable
price index or another commodity that is closely related to the even at this price level.” Numerous practitioners fail to appreciate
buyer’s business. Long-term contracts usually permit the price to the limitations of these time series in project valuations, or they
be reset to the market price, typically every 5 years. perceive stochastic price models as too complex to be practical.
Although a gas producer can use swing contracts to mitigate Begg and Smit (2007) provided a more-detailed commentary that
commodity-price risk by selling a gas stream at a forward price, explains why stochastic price models are needed for correct valu-
prudent use of this strategy requires understanding its cost. The ation and reviewed a range of models that are applicable in the oil
value of a swing contract is determined by the overall amount of and gas context. They also gave formulae for simple implementa-
traded commodity, the stipulated flexibility and constraints, and tion of the models in a spreadsheet and described how historical
the unknown future price development of the commodity. This prices can be used to provide information about relevant model
study investigates the distribution of the value associated with a parameters.

216 October 2011 SPE Economics & Management

 Should the single available swing option be exercised in Period 2?

Probability

Gas price
Expected price
Strike price

Oil price today

Periods
Probability

If the option is exercised in Period 2 the owner foregoes the

possibly higher gas prices in Periods 7 and 10

Oil price next week

Gas price
Probability Potential price

Strike price

Oil price next year

Fig. 1—The relative probabilities of future oil prices.

Fig. 2—The holder of a swing contract has to decide whether
to exercise a single swing option in Period 2. Doing so would
forgo the possibility of capitalizing on potentially higher prices
A common misconception is that stochastic price models pre- in the future. Periods are indicated by blue and green boxes, the
dict the future hydrocarbon price. In reality, a stochastic process latter identifying periods in which there is value in exercising
describes a probability distribution for an uncertain variable at the option. In summary, the holder of a swing option is posi-
some point in the future and the development of this probability tioned to capitalize on any price spikes that are expected during
distribution over time. A stochastic price model does not forecast the contract period, and the value of the option is determined by
specific future prices but may allocate a higher probability to some price extremities, rather than by the expected price. To estimate
price ranges than to others. Given a present commodity price, the the option value correctly and develop a policy for when to
likelihood that tomorrow’s price will be close to today’s price is exercise it, it is necessary to model the price volatility.
larger than the probability of a significantly higher or lower price.
For example, assuming an oil price of USD 80/bbl today, a higher
probability would be assigned to tomorrow’s oil price being USD given time period. Suppose that because of the price spike, there is
85–95/bbl than to its being USD 150–160/bbl. However, forecast- positive value in exercising the option in Period 2. However, to do
ing farther into the future becomes progressively more uncer- so would remove the possibility of exercising it in a later period,
tain. This principle, illustrated in Fig. 1, can be mathematically which might have even more value (e.g., in the lower part of Fig.
described by a diffusion equation that forms the basis for stochastic 2). To make that decision, we need to know the value of exercising
processes used generally in real option valuation. (The graph in in Period 2 compared with the expected value of holding the option
Fig. 1 is skewed because the price cannot become negative and to exercise in a later period. Intuitively, the value of holding must
because there is more capacity for it to increase than to decrease). fall as we approach expiry of the option in the last period.
The lower panel in Fig. 2 shows a typical price profile generated
in a single Monte Carlo iteration of a stochastic-process model. Forest of Trees
Stochastic price models also capture the conditional nature of Two schemes have been proposed for the valuation of swing con-
price development. The expected future development of commod- tracts: (1) stochastic dynamic programming and (2) Monte Carlo
ity prices is conditioned on the present commodity price (Schwartz simulation (Haarbrücker and Kuhn 2009). This section briefly
and Smith 2000; Willigers 2009). describes the former, because it provides some generic insights
The value of an option is realized by its exercise, and its exer- into the solution approach. The latter approach is discussed in more
cise timing will depend on the actual price variability, rather than detail in subsequent sections.
on the expected price. Thus, we need to model the price variability, In the stochastic dynamic programming approach, the valu-
using stochastic price processes, for two related reasons. First, to ation problem is generally solved using a forest of trees (FoT)
be able to place a value on the option, we need to model how it (Lari-Lavassani et al. 2001; Jaillet et al. 2004). The FoT approach
will be used (exercised). Second, if the contract limits the number is an extension of the binomial real option valuation method (Cox
of times the option can be exercised, we need to develop a strat- et al. 1979; Copeland and Antikarov 2001), in which a series of
egy that ensures the best possible timing. To illustrate, consider probability trees is created and combined.
the holder of the option to be a gas retailer who obtains gas from In the binomial method, a discrete set of possible future states
the producer at the contract “strike price” and then sells it in the of an uncertain quantity (e.g., gas price) are developed starting
domestic market at the “gas price,” as shown in Fig. 2. Assume that from a known state (e.g., at time zero). At the next period, the value
the contract holder can exercise the option for an increased supply will either move up by a certain proportion, u, or move down by a
from the producer in only one of the time periods and that we are certain proportion, d. Each subsequent period adds one additional
indeed able to calculate the value of exercising the option at any branch, generating a tree of spreading future states (Fig. 3). This

October 2011 SPE Economics & Management 217

 Period 4

Period 4
u=upward movement
d=downward movement
u>d u 4x

Period 3

Period 3
u=upward movement u 4x
x=value at Period 0
d=downward movement
p=chance of upward movement
u>d

Period 2

Period 2
Φ=exercise value
x=value at Period 0
u 3dx

Period 1

Period 1
u 3dx

Period 0

Period 0
u 2d 2x
ux u 2d 2x
x

dx
u d 3x
u d 3x

Max(pud 3x+(1−p)d 4x,Φ

d 4x
d 4x

Fig. 3—The development of a binomial tree. Fig. 4—Solving a binomial tree. In the optimization of the green
node, a choice is made either to exercise an option and real-
ize a value at Period 3 or to save the option with an expected
value in Period 4.
is an example of a recombining tree in which an up/down or a
down/up movement results in the same state.
The binominal tree is solved for its economic value by step- of a gas-storage facility. Willigers and Bratvold (2009) provided a
ping backward in time down through the tree (Fig. 4). Starting detailed description of the LSM method and applied it to determine
at the right side of the tree, a decision is made at each period as the value of flexibility associated with a gas asset if the asset owner
to which of the following two choices is greater: the actual value had the option to optimize gas-production rates.
that can be realized by exercising the option in this period, or the The LSM methodology allows for the asset optimization (i.e.,
expected value of saving the option for a later period. Using p to optimal exercise decision strategy) to be separated from the
represent the probability of an upward movement (making 1–p price-evolution model. The modeling flexibility created by this
the probability of a downward movement), the expected value in separation is used in this study to model the main characteristics
a subsequent period is given by pux + (1–p)dx. of real swing contracts. Numerous swing contracts do not permit
Hence, a general formulation of the optimization procedure large adjustments in the volume of the traded commodity between
is given by periods. Instead, they provide a maximum allowable increment for
production to be increased or decreased. In contrast to Dörr (2003),
max[ pux t + (1 − p)dx t ,  ]. . . . . . . . . . . . . . . . . . . . . . . . . . . (1) this study addresses the resulting complexity. In addition, the gas-
production-decline rate has been modeled as an uncertain variable.
The optimized values for all states at Period tn are captured and enter In contrast to the FoT approach, the LSM method also allows for
the optimization procedure at Period tn-1. The binomial real option value simple implementation of these complexities and for the develop-
is determined by collapsing all branches into a single node at t0. ment of stochastic processes for multiple uncertainties that affect
When using the FoT approach to value a swing contract, a series the value of a swing contract (using the FoT approach, a separate
of trees is developed, with each tree representing one state of the set of lattices has to be developed for each source of uncertainty).
contract in terms of the number of swings, q, left to be exercised. Typical binomial models simulate cash flow (e.g., Copeland and
In solving the FoT at each node for Period tN to t0, where N = Antikarov 2001) opposed to the separate uncertainties, as is easily
total number of periods, the optimal choice is made between two performed using the LSM methodology. Furthermore, previous
alternatives: (1) exercising one swing option and realizing its value studies valued swing contracts from the perspective of the gas
or (2) saving all swing options for a later period. The continuation trader, whereas this study also addresses the perspective of the
value (expected value) of the latter alternative is captured in Tree gas producer.
m (blue nodes in Fig. 5) while the continuation value of the first
alternative is captured in Tree m – 1 (red nodes in Fig. 5).
Although the FoT method is simple to implement for a simple Description of the LSM Model
problem, the implementation and calculation requirements grow Optimization Procedure. The LSM analysis applied here starts
exponentially with the number of factors accounted for in the by simulating a set of 5,000 “paths” for each of the uncertain
model, making this approach impractical (the computing-time variables: gas price and the decline rate. A “path” is one realization
requirements grow exponentially) for realistic problems that are of how the uncertain variable might evolve over a time horizon of
rich in complexities. 5 years, divided into discrete periods of 2 months each. Although
continuous stochastic processes are used in the model, a single
LSM Real Option Valuation value for the uncertain variables is determined for each period. The
The LSM approach, as described by Jacques (1996) and Longstaff variables used in the analysis are listed in Table 1.
and Schwartz (2001), was first applied to the valuation of a gas The value of a single swing option in the final period of the con-
swing contract by Dörr (2003). Haarbrücker and Kuhn (2009) tract, Period T, can be determined easily. Because the swing option
used the LSM method to value swing contracts in the electricity has no value once the contract has ended, the value is simply
market, and Boogert and de Jong (2006) used LSM in an invest-
ment problem closely related to swing contracts—the valuation max[ST ( w) − K , 0] ⋅ c, . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2)

218 October 2011 SPE Economics & Management

 4
d
rio
3
d

Pe
rio
2
d

Pe
io
1

r
d

Pe
0

io
d

r
Pe
rio
Pe
One-swing options

Hig
h ga
s pr
ice

Zero-swing options

Low
gas
pric
e

Fig. 5—A recombining FoT used for the valuation of a swing contract.

where ST (w) is the gas price in Period T for path w = 1, …, 5,000; is larger than the expected value of the option in Period T. More
K is the contract price of one gas unit; and c is the gas volume generally, the value of the swing option in Period t is given by
traded in Period T.
This valuation is made for all paths and all states of q, the num-
ber of remaining swing rights (in Period T the value of the swing max{[St(w) – K]∙c + [t,St(w),q–1], [t,St(w),q]}, . . . . . . . (3)
option is the same for all states of q because only a single option
can be exercised per period and the swing option rights have no where [t,St(w),q] is the continuation value (conditioned on the
value once the contract has ended). In Period T – 1, the swing option state at time t – 1), defined at Period t, with commodity price S(w),
will be exercised if the value of exercising the option in that period and where q is the number of remaining swings.

TABLE 1—DEFINITION OF VARIABLES

Symbol Description

t Period
∆t Length of a period
T Total number of periods
rf Risk-free rate
w Path or iteration
c Total gas volume traded in one period
cmin Minimal gas volume traded in one period
cmax Maximum gas volume traded in one period
∆c Difference in volume of traded gas between two subsequent periods
CC Total amount of contracted gas
Pt (w) Gas produced at Period t and Iteration w
K Strike (contract) price for 1 gas unit
St (w) Spot market gas price at Period t and Iteration w
q Swing option
Q Total number of swing options
q′ Swing option increments
Q′ Total number of swing option increments
ψ(t, St (w), q) Continuation value
ψ̂(t, St (w), q) Estimated continuation value

October 2011 SPE Economics & Management 219

 Swing option increments used per period:

2 1 2 3 4
′=
1
′=
2 3
′= ′=
4 5
′=
q t= q t= q t= q t= q t=

cmax=c 5 Trading ceiling

Trading c4
volume
c3

c2

cmin=c 1 Trading floor

t=1 t=2 t=3 t=4 t=5

Trading periods

Cumulative
consumed swing
option increments

t=1 t=2 t=3 t=4 t=5

Trading periods

Fig. 6—The traded volume per period is represented by a series of discrete states bounded by a floor and ceiling. Moving from
one period to the next, the volume will either increase or decrease by one volume increment represented by one swing incre-
ment. The coloring illustrates what is consumed in the subsequent periods [green = uneven periods (1, 3, and 5), and yellow =
even periods (2 and 4)].

The continuation value, (•), equals the expected remaining This relationship effectively uses the value of the stochastic
value of the swing contract at Period t given the actions taken variables in Period t to estimate the future continuation value of
in this period. The optimization procedure, as shown in Eq. 3, is the Period t + 1. Given that our interest is in the continuation value
executed for each path and all states of q starting in Period T – 1 in Period t, an adjustment for the time value of money needs to be
looping backward in time until Period t = 0. A continuation value made (in this case, continuous discounting):
(•) for each state of q is stored in a matrix defined for each path
ˆ [t , St ( w), q] = ˆ [t + 1, St ( w), q ] ∗ e f , . . . . . . . . . . . . . . . (6)
− r t
and period. Upon exercising a swing option, the data transfer
between different matrices is analogous to moving between trees
in the FoT method (Fig. 4). where rf represents the risk-free rate and Δt the length of each
period.
Estimation of the Continuation Value
Changing Traded Volumes Between Periods
In the LSM methodology, the continuation value (•) in Period t and
Numerous swing contracts constrain the amount of change in
Swing q is estimated using a least-squares mean regression in which
commodity trading between periods. Modeling this requires that
one or a series of stochastic variables are regressed against the out-
the volume of commodity traded in a period be treated as a state
come modeled in the simulation. The regression formula is given by
variable. We assume that in any given period, the owner of the
W
contract will trade at either the maximum or minimum permis-
mint ,q = ∑ [Yw − ( + bSt ( w))]2 . . . . . . . . . . . . . . . . . . . . . . . . . . (4) sible volume (that is, take full advantage of market conditions or
w =1 make no change). Thus, c can be modeled as a discrete state vari-
able (upper part of Fig. 6). Given the floor and the cap on traded
where Yw is the simulated value in iteration w and  and b are volumes per period and the constraints on trading adjustments
coefficients to be determined in the regression. between subsequent periods, one can define c  [cmin, ...., cmax] and
The gas price, St(w), is modeled stochastically and included ∆c = |c – c |. This type of problem, in which the solution is one
i j
in the regression analysis. A regression analysis is made for of two extreme states, is sometimes referred to as a “bang-bang
each Period t and possible state of q and results in an estimated type” (Jaillet et al. 2004).
continuation value (whose notation we simplify to yw) in Period A consequence of the constraints on temporal changes of
t + 1 (in the binomial model, the continuation is known and given trading volumes is that the gas trader does not necessarily purchase
by  [t , St ( w), q] = p ⋅ u + (1 − p) ⋅ d ) : ˆ [t + 1, St ( w), q] = yw =  + bsw . c , the maximum allowable gas volume. In order to account for
max
this potentially lower volume bought on swing options, the variable
ˆ
+ (1 − p) ⋅ d ) :  [t + 1, St ( w), q] = yw =  + bsw . . . . . . . . . . . . . . . . . . . . . . . . . (5) q is introduced to indicate the number of swing increments. The

220 October 2011 SPE Economics & Management

 TABLE 2—PARAMETERS USED IN THE STOCHASTIC PROCESSES

Parameter Gas Price Rate of Production Decline

Annual volatility 0.4664 0.5

Annual reversion speed 0.22 0.22
Initial value 4 EUR/Mscf 0.25% /yr
Equilibrium value 4 EUR/Mscf 0.25% /yr
Prices in December are 70%
Seasonal fluctuation None
higher than in July

number of swing increments q purchased in each period equals from the long-run mean x, we would expect that in ln(2)/ years
c − cmin xt will have reverted half way to the long-run mean. By analogy
c . with physics, we denote the term ln(2)/ as the “half-life” of the
mean-reverting process.
Conversion of Total Volume Traded Into
Swing Options Gas-Price Model
Numerous contracts do not constrain the number of swings but The gas-price model is parameterized on the basis of a data set of his-
instead define an overall commodity volume traded during the torical Bacton gas prices from October 2000 to December 2007. The
contract and a floor and ceiling for each trading period. Given that
the problem is a bang-bang type, the conditions of such contracts parameters required in the price model are the gas-price volatility,
can be translated into a specific number of swing options, as reversion speed, reverting price level, and seasonal price fluctuation.
given by All parameters used in the stochastic models are listed in Table 2.

Q=
(CC − cmin ) ⋅ T , . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (7) Gas-Production Model
(cmax − cmin ) ⋅ T The uncertain production rate of a gas field is also modeled by
where CC is the total volume of contracted commodity and T the a stochastic process. The production rate follows an exponential-
decline function. Given the decline rate and the flow rate at the
number of trading periods. (cmax −swing
The number of swing increments Q =in the
cmin )
⋅contract
Q is start of a period, the remaining reserves can be calculated. As the
given by:  c decline rate for each path changes over time, the expected value
of recoverable reserves will change accordingly.
Q =
(cmax − cmin ) ⋅ Q. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (8)
c Value Distribution Between Producer and Trader
Although swing contracts can help gas producers to mitigate risk
Description of the Stochastic Models of adverse future conditions, gas producers would benefit by being
An Ornstein-Uhlenbeck mean-reverting stochastic process (Wil- more knowledgeable about what quantity is effectively paid when
ligers and Bratvold 2009) has been used to simulate the logarithm committing a gas stream to a swing contract.
of the gas spot price and the overall gas-production rate. Future The value of a swing option for the gas buyer is given in Eq. 3.
values are described by the stochastic differential equation The revenue generated from the gas stream for the gas producer
consists of three components: (1) payment by the gas-buying party,
dx t =  ( x − x t )dt + s dWt , . . . . . . . . . . . . . . . . . . . . . . . . . . . (9) (2) gas sold on the spot market, and (3) a penalty if insufficient gas
is produced to meet the terms of the swing contract. The revenue
where x is the long-run mean to which the log of the variable for the gas producer is given by:
reverts,  describes the strength of the mean reversion, s is the
volatility of the process, and dWt represents increments of a standard K ⋅ c + St ( w) • max[(Pt (w) – c), 0][St ( w) − K ]*
Brownian motion process. As shown by Dixit and Pindyck (1994), max{[c − Pt ( w)], 0}, . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. (10)
this implies that the log of the gas prices, xt, is normally distributed
−2 r f
with mean E[x(t)] = x + (x0­ – x)e −2 rf and variance s (1 − e ).
2
where Pt(w) is the amount of produced gas in Period t and Path
2 w = 1, ..., 5,000.
This shows that deviations from the long-run mean will fol- Gas produced in excess of the amount dedicated to the swing
low an exponential decline. Given a current log value of x0 away contract is sold at the spot price to the market. It is assumed that
if the gas produced, Pt(w), is insufficient to cover the gas volumes,
10,000 c, the producer will purchase the shortfall at the spot price and
9,000
Value of swing contract

sell this purchased gas at the agreed rate, K, to the gas trader. In
8,000 scenarios where the spot price is less than the contract price, the
7,000 gas producer will generate positive revenue by buying gas at the
6,000 spot price and selling it to the gas trader at the contract price.
5,000
4,000 Results
3,000 The Value of an Incremental Swing Option. In the initial analy-
2,000 sis, a model with simplified assumptions was used to (1) investigate
1,000 the relationship between the number of swing options and the value
0 of a swing contract and (2) obtain insight into the minimum gas
0 0 10 15 20 25 30 35 prices that are required to justify the execution of a swing option.
Number of swing options In this basic model a swing contract is modeled with any number
of swing options, Q, and the traded gas volume in each period is
Fig. 7—The value to the producer of a swing contract as a func- either cmin = 0 or cmax.
tion of the number of swing options given that a constant total The results shown in Fig. 7 are for a fixed total volume of 3,000
volume traded in the swing contract remains fixed. MMscf to be traded through exercise of the options. The results

October 2011 SPE Economics & Management 221

 One-swing option perfectly exercised Two-swing options perfectly exercised

Gas price

Gas price
Strike price

Periods Periods

Three-swing options perfectly exercised Swing options yield a positive payoff

in four out of 11 periods
Gas price

Gas price
Strike price

Periods Periods

Fig. 8—The marginal value of a swing option in a swing contract declines with the number of swing options because these
incremental swing options are exercised at progressively smaller price spikes. Periods are indicated by colored boxes. Green
boxes indicate where there is value in exercising a swing option, and red boxes mark those periods where there is not.

show how the value changes as a function of how that volume is from this one price spike that has the highest price (see Fig. 8 for
traded. If the contract specifies that only one option can be exer- more details).
cised, then all 3,000 MMscf (c_max = 3,000 MMscf) is traded in The minimum gas price that justifies the execution of a swing
one transaction and the value of the contract is EUR 9.141 mil- option has been determined as a function of time and the number
lion. At the other extreme, if the contract allows 30 swings, each of swing options available to the owner. The results shown in Fig. 9
a trade of 100 MMscf (c_max = 100 MMscf), the value falls to suggest that the minimum price point for a single-swing contract
EUR 2.333 million. Thus, the value of the contract decreases as remains constant at approximately EUR 8/Mscf for the first 30
the number of swings increases (equivalently, as the traded volume periods, but progressively declines to EUR 4/Mscf, the strike price,
per swing decreases). The reason that fewer options (with large in the final periods of the swing contract. The minimum gas price
permitted trade volumes) are more valuable is as follows. During required to justify the execution of a swing option decreases from
the contract period, one can expect one large price spike and a EUR 8/Mscf to 5.5/Mscf when the number of available swing
large number of smaller spikes—the more swing options that are options is increased from 1 to 20 (Fig. 9). Gas producers can expect
used to buy the same overall volume of gas, the less one can profit increased gas demands toward the end of the gas swing contract

10
9
Minimum spot price, EUR

8
7
1 swing
6
5 2 swings
4
4 swings
3
2 10 swings
1
20 swings
0
0 5 10 15 20 25 30 35 40 45 50 55
Period

Fig. 9—The minimum gas price, in EUR, to justify the execution of a swing option as a function of time. The relationship is shown
for a series of contracts with different number of swing options.

222 October 2011 SPE Economics & Management

 9,500 25,000

Value of swing contract

20,000 Gas trader
9,000

Value, million EUR

15,000 Gas producer
8,500 10,000

8,000 5,000
0
7,500
–5,000
7,000 –10,000
0 500 1,000 1,500 2,000 2,500 3,000 3,500 8,354 4,167 2,500 418
Delta c Volume of produced gas

Fig. 10—The value of a swing contract, in millions of EUR, from Fig. 11—The value, in millions of the contracted gas.
the perspective of the gas trader as a function of the total vol-
ume of contracted gas for different assumptions of Δc.

In the final analysis, the volume of gas to be produced while the

(the trend can be distorted by, for example, annual fluctuations in swing contract is valid is modeled probabilistically. The impact of
gas demand), and this larger demand will be more pronounced such production uncertainty is strongest at low production volumes
if the contract allows for larger, per period, gas quantities to be (Fig. 12), in which the gas producer has increased risk of having
purchased. to make penalty payments.
Trading Restriction Between Trading Periods Discussion
The impact of capping the allowable, between periods, adjustments The Value of Incremental Swing Options. The holder of a swing
in trading volumes, Δc, has been assessed. The number of states contract aims to exercise their swing options when gas price is
that c can adopt is varied between 1 and 10. Fig. 10 shows that, high. Consider a single-swing contract. Assuming that the holder
given a total volume of traded gas of 3,000 MMscf, the value is able to predict the future perfectly, the option would be exercised
decreases from 9,141 million EUR for Δc = 3,000 MMscf to 7,500 when the maximum gas price is realized over the duration of the
million EUR for Δc = 300 MMscf. contract (Fig. 8). Two swing options of a double-swing contract are
exercised at the highest and the additional third swing option in a
The Value Distribution Between Gas triple-swing contract is exercised at the third-highest price spike
Producer and Trader (Fig. 8). Following this logic, it is clear that the owner of a swing
The value creation for the gas producer and the gas trader as a contract is capitalizing on progressively smaller price spikes when
function of the amount of produced gas is shown in Fig. 11. The swing options are added into the contract. Ultimately, there might
total amount of traded gas is 3,000 MMscf in all scenarios. Any not be any value creation by further addition of swing options into
shortfall in the amount of gas produced under the swing contract the contract (Fig. 8).
is purchased by the gas producer on the spot market. A related dynamic is that the minimum gas price required to
The contract price is assumed to equal the expected spot price. justify the execution of a swing option decreases as the number
Hence, in the absence of price volatility, the gas producer should be of available swing options increases (Fig. 9). This is because of
indifferent between selling the gas on the spot market or in a swing the reduced risk of not being able to capitalize on a future high
contract. Under these assumptions, the gas trader is protected from price, making it feasible for the owner to lower the price threshold
the risk of the producer’s being unable to deliver the required gas, that warrants the execution of a swing option. Fig. 9 also shows
and the value of the contract from the perspective of the gas trader that, over time, a progressively lower price level is required for
is thus fixed. The value of the gas stream from the perspective of the execution of a swing option. This trend relates to two factors.
the producer consists of revenues from the swing contract along First, the chance of improved market conditions decreases as the
with revenues generated by gas sales on the spot market and cor- contract approaches maturity; that is, there is less time available
relates positively with the total amount of gas produced. The gas to exercise the option. Second, swing options not exercised during
producer incurs a loss at low production volumes because of the the contract period lose all their value. This latter feature is also
obligation to buy gas at the spot market and subsequently sell this documented by Willigers and Bratvold (2009).
purchased gas at a loss to the gas trader.
The Distribution of Value Between the Gas
Trader and Producer
25,000 Gas from a single producing asset is often sold on both swing
contracts and the spot market. Given that gas traders will want to
20,000
maximize the volume of gas they purchase during periods of high
15,000 gas prices, the amount of gas remaining for the producer to sell at
a premium price will be reduced. Conversely, during periods of low
10,000 gas prices, the producer will sell less gas on swing contracts and
Value

5,000 therefore have more to sell on the spot market, at a low price (Fig.
13). Although gas producers could optimize production rates with
0 respect to gas prices, such trading strategies are rarely implemented
Certain production volumes
–5,000
effectively (Willigers and Bratvold 2009).
Uncertain production volumes Swing contracts can be an effective tool to hedge against
–10,000 market price volatility but gas producers would benefit by better
0 2,000 4,000 6,000 8,000 10,000 understanding the cost of such insurance. The cost of the hedge
Volume of produced gas equals the profit made by the gas trader, given that the gas is ulti-
mately sold on the spot market and the producer has enough gas
Fig. 12—The impact of uncertainty on the value creation, in to supply the amount of gas as stipulated in the swing contract.
millions of EUR, for the gas producer. The cost of the insurance increases with market volatility and the

October 2011 SPE Economics & Management 223

 A. The producer sells gas on the swing contract in
the blue periods and on the spot market in
the yellow periods

Cost of insurance
Gas price

Strike
price

Net profit trader

Periods

Gross profit gas trader

Value

Total gas revenue

Net profit gas produer

B. The gas revenue for the producer in yellow
and the gas trader in blue

Cost of gas for trader

Gas revenue

Periods Total Gas trader Gas producer

Fig. 13—The distribution of value between the gas trader and the producer and the cost of insurance against market risk. Panel
A indicates those periods in which the gas trader exercises their swing options. The periodic revenues, as shown in Panel B,
are aggregated in Panel C to illustrate the cash flows of the gas trader and gas producer.

extent to which gas traders can benefit from price fluctuations. constraints on the minimum and maximum amounts of gas stored
In the extreme, when the gas price equals the strike price in all at any given time. The choice to store or extract gas will be
periods (i.e., no price volatility), the gross profit and the cost for determined by the gas price, and, analogous to the swing-contract
the gas trader would be equal and the cost of the insurance would problem, there will be greater value in one or the other option.
be zero. Gas producers can reduce the cost of the insurance by, for
example, introducing a cap on the maximum difference of volume Conclusions
of gas traded in consecutive periods because such measures will This study intended to raise awareness among the upstream oil and
reduce the extent to which a gas trader can benefit from price gas community of the factors that affect the value of flexibility.
volatility (see Fig. 10). Our analysis formally quantified the value of flexibility associated
The expected cost of the insurance paid by the gas producer is with swing contracts from the perspectives of both the gas producer
raised significantly if there is a risk that not enough gas is produced and the gas trader (buyer). Gas traders realize that the flexibility
to fulfill the gas contract (Fig. 12). In this study, the gas producer associated with swing contracts has value, as demonstrated by the
buys the gas shortfall at the spot market and subsequently sells the widespread use of swing contracts. At present, the parties buying
gas at the strike price to the gas trader. Although this arrangement gas from upstream exploration and production companies are the
could yield a profit for the gas producer if the spot price is lower main beneficiaries of the option to trade increased volumes of gas
than the strike price, given that the largest volumes will be traded during select periods over the lifetime of a contract. Gas produc-
on the swing contract when the gas price is high, the net result is ers would benefit by improving their understanding of the value
that the profitability of the gas producer is reduced. associated with the flexibility of swing options and thereby ensure
that they receive a fair share of the value created during periods
Expansion of the Model of increased demand and prices. By failing to do so, they risk
The model developed in this study demonstrates that the LSM transferring value to the traders at no cost.
approach can be used to value swing contracts and their common Recently, several techniques have been proposed to evaluate
characteristics. However, numerous variations of swing contracts the flexibility associated with swing contracts. However, only the
are traded and some aspects have not been addressed here or have LSM method seems to have the flexibility to address the real-life
been simplified. Numerous contracts allow for daily adjustments complexities associated with swing contracts.
of production volumes as opposed to bimonthly, and the penalties The analysis of a swing contract is a showcase for the applica-
for not meeting the contract terms are generally more complex tion of stochastic price models in exploration and production proj-
than assumed here. However, the model can be readily extended ect evaluation. The holder of a swing option aims to capitalize on
to incorporate these complexities. price spikes that are expected to occur during the contract period,
Although we focused on swing contracts, the analysis of a gas- and the value of the option is determined by price extremities,
storage facility is remarkably similar (Boogert and de Jong 2006). rather than by the expected price. Hence, the use of an expected
The operator of a gas-storage facility has the option in each period price forecast will attribute no value to a swing option. To correctly
to store gas or extract gas. There will be operational constraints estimate the option value requires simulating the price volatility
on the rate at which gas can be extracted and stored and capacity with a probabilistic model.

224 October 2011 SPE Economics & Management

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University of Oxford, (29 September 2003). Bart J.A. Willigers is a principal consultant at Palantir Solutions.
Haarbrücker, G. and Kuhn, D. 2009. Valuation of electricity swing options Currently, he is working with a number of clients to improve
corporate decision-making abilities and valuation techniques.
by multistage stochastic programming. Automatica 45 (4): 889–899.
Willigers has published numerous papers on decision analysis,
http://dx.doi.org/10.1016/j.automatica.2008.11.022. economic-valuations methodologies, and geology. He holds
Jaillet, P., Ronn, E.I., and Tompaidis, S. 2004. Valuation of Commodity- a PhD degree in geology and an MBA degree in general
Based Swing Options. Management Science 50 (7): 909–921. http:// management. Willigers is also a technical editor for SPE E&M.
dx.doi.org/10.1287/mnsc.1040.0240. Steve H. Begg is a professor and Head of the Australian School
Jacques F, C. 1996. Valuation of the early-exercise price for options of Petroleum, University of Adelaide. He teaches, researches,
using simulations and nonparametric regression. Insurance: Mathemat- and consults in the area of decision-making under uncer-
ics and Economics 19 (1): 19–30. http://dx.doi.org/10.1016/s0167- tainty, including economic evaluation and psychological and
6687(96)00004-2. judgmental factors in eliciting expert opinions and uncer-
tainty assessments. Begg has previously worked for BP in the
Joskow, P.L. 1985. Vertical Integration and Long-term Contracts: The Case
area of reservoir characterization and as Director for Strategic
of Coal-burning Electric Generating Plants. JLEO 1 (1): 33–80. Planning and Decision Science for Landmark. He has a par-
Joskow, P.L. 1987. Contract Duration and Relationship-Specific Invest- ticular focus on investment decisions at the project/asset and
ments: Empirical Evidence from Coal Markets. The American Eco- portfolio levels. Begg holds a PhD degree in geophysics. He has
nomic Review (AER) 77 (1): 168–185. twice been an SPE Distinguished Lecturer on decision making
Kaminski, V., Gibner, S., and Pinnameneni, K. 2004. Energy Exotic and economic-evaluation topics and is a regular contributor
Options. In Managing Energy Price Risk: The New Challenges and to forums and annual technical workshops on the topic. Begg
Solutions, ed. V. Kaminski, Sec. 1.4, 83–154. London: Risk Books. was instrumental in starting SPE E&M. Reidar B. Bratvold is a
Keppo, J. 2004. Pricing of Electricity Swing Options. The Journal of professor at the University of Stavanger and at the Norwegian
Institute of Technology and Science, where he is teaching and
Derivatives 11 (3): 26–43. http://dx.doi.org/10.3905/jod.2004.391033.
supervising graduate students performing research in uncer-
Lari-Lavassani, A., Simchi, M., and Ware, A. 2001. A Discrete Valuation tainty assessment, risk management, investment analysis, deci-
of Swing Options. Can. Appl. Math. Q. 9 (1): 35–74. sion sciences, and market-based valuation. He holds a PhD
Longstaff, F.A. and Schwartz, E.S. 2001. Valuing American options by degree in petroleum engineering and an MSc degree in math-
simulation: a simple least-squares approach. Rev. Financ. Stud. 14 (1): ematics, both from Stanford University. Reidar is coauthor of the
113–147. http://dx.doi.org/10.1093/rfs/14.1.113. SPE book Making Good Decisions.

October 2011 SPE Economics & Management 225