Valuing production capacities on flow commodities

Price risk management for flow commodities (such as natural gas, oil, and electrical power) is not trivial due to restrictions on storability of the underlying. To be protected against price spikes, consumers purchase diverse swing–type contracts, whereas contract writers try to hedge them by appropriate physical assets, for instance, by storage utilities, by transmission and/or production capacities. However, the correct valuation of such contacts and their physical counterparts is still under lively debate. In this approach, we suggest an axiomatic setting to discuss price dynamics for contracts on a flow commodity. It turns out that a minimal set of reasonable assumptions already provides a framework where the standard change–of–numeraire transformation converts a flow commodity market into a market consisting of zero bonds and some additional risky asset. Utilizing this structure, we apply the toolkit of interest rate theory to price the availability of production capacity on a flow commodity.