Dynamic trading strategies for storage

We consider a dynamic model of an oligopolistic market with demand shocks, in which a storage unit buys and sells over time subject to a capacity constraint. To make progress in this stochastic game with constraints, we restrict attention to simple heuristics, and we can characterize the optimal policy of a storage unit in this restricted class of strategies. The heuristics, the exogenous stochastic process and the capacity constraint interact to induce rich dynamics. The optimal policy is sensitive to the nature of demand shocks and to storage capacity. For a fixed capacity, the storage unit internalizes its unilateral market power; it acts like a monopolist on its arbitrage spread. We uncover a new phenomenon that we call continuation risk. It is a corollary of market power and induces the optimal capacity to be interior even absent investment cost. We discuss some implications.