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The Natural Gas Market
Sixty Years of Regulation and Deregulation
By Paul W. MacAvoy Yale University Press
Copyright © 2000 Yale University
All right reserved. ISBN: 0-300-08381-5
Chapter One
An Introduction to Regulation and the Performance of Gas Markets The price and production behavior of gas markets has been strikingly different from that in markets for other natural resources. Gas prices in constant dollars began to increase in the mid-1970s, peaked in 1982-1983, and have declined almost every year since then. Production peaked in the mid-1970s, after some years in which new discoveries of in-ground reserves failed to replace the annual take from operating wells; by the early 1980s, production had stabilized at 80 percent of peak levels, while reserves continued to decline.
Although this price spike characterized market behavior, it resulted not from supply-demand interactions but from distortions caused by the application of regulatory policies specific to the natural gas industry. The impact of regulation has been all-encompassing, on the well-head contract commitment of reserves, on production out of reserves, and on pipeline delivery of production to the city gate for distribution to final consumers.
Federal regulatory policy in the 1960s and 1970s placed limits on gas prices that caused significant nationwide shortages, and in response, new policy in the late 1970s then caused surpluses that closed down production facilities and led to dumping gas in spot markets. A Supreme Court decision of 1954 required federal regulatory control of the wellhead price of gas. It took until the late 1960s to implement this ruling at the Federal Power Commission (FPC). When controls became fully effective, prices and thus production were reduced to such an extent that shortages exceeded one quarter of total demands. To relieve these shortages, prices were deregulated, but only for production from newly developed reserves. By continuing the regulation of prices for production out of old reserves for seven more years, the commission forced deregulated prices for new supplies to such artificially high levels that supplies exceeded demands by the mid-1980s.
These policies were intended to improve industry performance. The purpose of regulation, underlying the commission's massive proceedings on case decisions and rulemaking, was to make consumers better off, by keeping prices at the low levels realized in the 1950s and 1960s, while still making it possible for producers to make adequate returns on investment in new reserves. Regulation meant to ensure the security of supply of gas reserves for production under pipeline contracts that extended from ten to twenty years in the future.
The FPC required contracts between the gas producer and pipeline buyer that would generate sufficient supply for the pipeline buyer to meet retail utility demands for gas at low cost over the lifetimes of installed lines. The requirement was to secure price and gas throughput against the vagaries of weather, the business cycle, and unexpected increases in user demands. But actual implementation of regulatory controls froze prices for long periods, generating supply volumes that were too limited to be secure. In fact, supply volumes were so low under price caps and later so high under partial deregulation that market-pricing processes were severely disrupted.
How could we explain results that deviate so far from the straightforward goal of a secure low-cost supply? They could have been intentional, as regulators sought to favor special interests with, for example, low prices, rather than improve the security of supply for all market participants. This argument would be plausible if some interest group turns out to have substantially benefited from the disorientation of markets caused by regulation. To assess regulation-induced gains or losses for all the major participant groups in gas markets, I develop, in the following chapters, estimates of prices and quantities with and without regulation. The "with regulation" prices reflect the historical prices on actual transactions. The "without regulation" prices are from a market model of the industry at the wellhead level that determines the sequence of supply-demand equilibrium prices from year to year for the past three decades. This model is developed in Chapter 2 to simulate market-clearing behavior over the period 1970 to 1995. In Chapters 3 and 4, I analyze three major regulatory regimes by examining differences in each regime between actual prices and volumes and the model market clearing prices and volumes. Gains or losses are estimated from price differences, for consumers and any interest group, and from quantity differences as the consumer or that interest group obtains more or less gas production.
INTRODUCING THE NATURAL GAS INDUSTRY
From wells deep into the earth's surface, companies extract a hydrocarbon derivative consisting mostly of methane mixtures, which is then refined to pure methane and transported as "pipeline quality gas" to be distributed to households, commercial establishments, and industry as heating fuel or chemical product raw material. The methane mixture comes from reservoirs containing crude oils, carbon dioxide, water, and other noncommercial substances. Pure methane is extracted from the other materials for injection (at a heating value of approximately 1010 Btu per cubic foot) into local and long-distance pipelines for delivery to wholesale or final customers.
The process begins with determination of the presence of in-ground deposits of methane and other hydrocarbons by drilling discovery wells into gas-bearing rock and sands. Seismic records are used to locate likely producing formations, a technique that has advanced over the past half century from crudely indicating various formations to, in the 1990s, actually detecting gas in these formations from three-dimensional databased simulations. As knowledge of the location of concentrated gas deposits (reserves) has developed, the drilling of producing wells has been made more exact and the recovery of a high percentage of in-ground volumes has been made more probable.
Large basins of reserves in North America have been located in Texas, Louisiana, and Oklahoma; more recent finds with improved technologies have added basins in Alberta, Colorado, and New Mexico. Markets for gas production have been located in the population and industrial centers of the East Coast, the Mid-Atlantic, and the West Coast. With major reserve basins historically in the Southwest, and concentrations of consumers in the coastal regions, the key step in industry development has been the construction of large-scale gas transmission and distribution systems. The rapid and successful growth of large transmission pipelines has made it possible for the industry to become the source of more than one-quarter of U.S. primary energy consumption.
In the system that was in place from the 1930s to the mid-1980s, transmission companies, which by and large have been separate from production and distribution companies over the past fifty years, purchased gas at the wellhead to transport and sell to local distribution companies, which then sold the gas to final consumers. The purchase at the wellhead established the "field price" of the product; the pipeline-delivered gas at the city gate was resold at the "city gate price"; that gas was finally resold again by the local distributing company at the "burner tip price."
This transaction demarcation has never been absolute. Gas at times has been gathered at the wellhead for transportation to the processing plant by field producers and sold there by the plant operator to the pipeline. At other times transmission companies have owned the processing plant or themselves have been owned and operated by local distribution companies, particularly if the local distribution company was in a gas-producing region. Transmission companies have sold gas directly to large industrial consumers, in what were retail transactions, without involving local distribution companies.
This rather straightforward industry structure, built around wellhead and city gate transactions, changed entirely in the 1990s. Field production was no longer sold at the wellhead or processing plant to pipeline companies that transport the gas long distances to population or industrial centers. New federal regulations removed the pipeline from the buying side of wellhead markets, to be replaced by brokers as well as wholesale and end-use customers. The new buyers sought transportation separately from the pipeline companies to complete delivery of their product at the wellhead to the city gate. Under the cloak of partial "deregulation," regulators no longer allowed pipelines to provide a package of gas plus transportation service, and instead they required open access to pipeline space for distributors and consumers.
In effect, entirely new markets developed at various intersection points, or "hubs," in pipeline systems for gas and for pipeline space to the next intersection point. Markets also developed for in-ground storage space, to allow gas delivered off-season to be used to meet peak heating season demands at some population center close by. Secondary markets for transportation quickly developed, in which buyers of pipeline space resell excess space, in competition with pipelines offering primary contract space. New contracts developed for hedging both gas and pipeline space agreements in commodity exchange contract markets.
In any broad survey of these original and newer markets there is the threshold issue of explaining industry price and production behavior. The issue is whether natural gas, a resource in reserve deposits, has been "running out," that is, becoming more scarce as reduced results from the reserve discovery process leads to systemic price increases and production declines. Natural gas reserves declined by 35 percent in the 1970s, but then by only 3 percent in the 1980s, while production in the two periods declined by 8 and 4 percent, respectively (fig. 1.1). Reserves declined again by 3 percent in the first half of the 1990s, but production increased by 5 percent. Thus, since 1988 a smaller reserve stock has supported a higher rate of production.
If depletion has set in, then wellhead transaction prices would have had to systematically follow a certain path over time. As developed by Harold Hotelling in 1931, in the depletion phase of a natural resource, current price equals the present value of expected future price net of any difference in extraction costs; that is, prices increase in percentage terms by the rate of interest. In 1978, Robert S. Pindyck developed this relationship more fully by indicating that price increases equal the difference between the rate of interest and changes in the costs of extraction, so that if technology reduces costs, then price changes can be negative. These price increases or decreases follow from moving supply up or down the demand function; in the Hotelling case, as price increases then production declines, but in the Pindyck case the secular price declines take place as production increases.
Prices for 1970-1996 follow a pattern different from that in depletion in a natural resource industry. Rather, it is an inverted "U," with a fifteen-year period of increase and a fifteen-year period of decline (fig. 1.2). The lowest price, for gas to the pipeline at the wellhead, did not increase in constant dollar terms before 1973, but at that point and continuing to 1978, it increased at an annual rate of more than 33 percent. Production increased each year to 1974, then fell back to 1968 levels for the rest of the period. From 1978 until 1983, prices at the wellhead continued to increase at approximately 10 percent per annum, while production held constant and then fell off 10 percent. From 1983 to 1996 prices declined by approximately 5 percent per annum, to return to 1980 levels, and production increased slightly, also to return to 1980 levels.
The annual price increase after 1975 was less than the increase in the rate of interest every year, and the rate of interest explains less than half of the year-to-year variance in prices. If we separate the thirty years into three time periods associated with three regulatory regimes, any trend in prices becomes insignificant. But the first regulatory ("price ceiling") period realized a substantial increase in the price level, the second ("phased partial deregulation") period also had increases in the price level, and the third ("restructuring") period had reduced prices.
At this stage of the analysis the conclusion is that year-to-year changes in prices have not followed the pattern of any industry subject to depletion of natural resources. Instead, each of the three periods of price change has been associated with a different regime of regulatory controls. The first two periods were marked by controls designed to contain rising prices, and prices increased while quantities decreased. The last period, after wellhead price controls had been eliminated and wellhead purchases had been unbundled from transportation, was marked by significant price decreases but continued quantity decreases.
INTRODUCING REGULATION
In the depths of the late 193os economy-wide depression, the Federal Power Commission began operations as a regulatory agency with statute authority to regulate the performance of electric power and natural gas companies "affected with a public interest." The Federal Power Act of 1935 assigned the commission the task of "assuring an abundant supply of electric energy throughout the United States with the greatest possible economy and with regard to the proper utilization and conservation of natural resources." The Natural Gas Act of 1938 brought under regulation companies in interstate commerce that undertook sales of gas for resale that were "affected with a public interest." Both statutes required the regulator to apply controls that would result in these companies better serving consumers. The commission was to secure "just and reasonable" prices for buyers of gas in wholesale markets to be passed on to household and business consumers.
The natural gas companies regulated by the commission turned out to include not only pipelines but also producers with gas for sale at the wellhead to be transported to the city gate across state lines. For forty years, FPC decisions and reviews of those decisions by the federal courts were based on the presumption that the intent was to protect consumer interests. To achieve "reasonable" prices, at the wellhead the commission required producers to sell gas at prices no greater than the average historical cost of finding and production. Given that such costs included a "fair" profit, the pipeline buyer paid that for the volume of gas taken and no more.
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