Natural Gas: Markets and Regulation

Before high-pressure pipelines were developed in the 1920s, gas was either consumed in the vicinity of its production or flared off as hazardous. Today, producers and marketers use interstate pipelines for deliveries to distributors and large consumers. The Federal Energy Regulatory Commission (FERC) determines cost-based pipeline rates, but pipelines are free to discount these (which they often do) in order to attract business. The rates of most local distribution companies (LDCs) that deliver and sell gas to final users are under state regulation, and the remainder are operated by municipal governments. Thus, gas is a vertically unintegrated industry in which dependable product flows require coordination among producers, pipelines, and LDCs. Since the 1970s, the industry has relied more heavily on coordination by market forces and less heavily on regulation, although the latter still plays a large role. Somewhat unusually, regulators themselves took major initiatives to bring competition to the industry, rather than protecting the status quo or imposing heavier regulations. The industry’s evolution is a case study in the replacement of inefficient economic institutions by efficient ones and the replacement of localized markets by national and global ones.

The Natural Gas Act of 1938 instituted pipeline regulation by the Federal Power Commission, which was reconstituted as FERC in 1978. The government justified regulation by asserting that pipelines were “natural monopolies” with scale economies so pervasive that a single line (or a handful to guarantee reliability) was the most economical link between producing and consuming areas. At the same time, state-regulated LDCs were (and continue to be) monopoly franchises with cost-based rates and the ability to pass on gas costs dollar for dollar to end-users. Until the mid-1980s, pipelines purchased gas from producers and resold it, with no markup, to LDCs.

In 1954, the Supreme Court ruled that federal regulation extended to the wellhead prices received by producers. Prices were to be determined using recorded costs. Regulators set the allowable costs of replacing exhausted wells at low levels that seriously discouraged exploration for new gas. Because oil prices remained unregulated through the 1960s (most gas is found in association with oil), gas shortages became serious only when new price controls on oil helped bring about the “energy crisis” of 1973–1975. Administrations of both political parties were unable or unwilling to acknowledge that the controls restricted the amount supplied and increased the amount demanded. Instead, they instituted direct controls on gas use, such as prohibiting construction of new gas-burning power plants, in the mistaken belief that falling reserves indicated the exhaustion of supply. In reality, reserves were falling because allowable prices were too low to make exploration profitable. Prior to 1978, intrastate markets were exempt from federal price controls, and they experienced no shortages.

A complex series of events in the early 1980s led FERC to lift all price controls in 1985, a promarket policy that the Supreme Court subsequently ratified. The decontrol followed on 1984’s Order 436, which effectively ended the earlier role of pipelines as purchasers and resellers of gas to LDCs. Order 436 (followed by Order 636 in 1992) turned pipelines into “open access” transporters for gas owned by producers, LDCs, and others. FERC still set maximum pipeline rates, but also left pipelines free to charge less to attract business. For the first time since the 1930s, producers and LDCs could contract for gas as they wished, sometimes with the help of a new industry of marketers. Soon these parties learned to use the new rules to trade rights to pipeline transportation among themselves and to repackage those rights into more valuable combinations. Although pipelines may be natural monopolies, exchangeable transport rights allowed competitive markets to allocate much of their capacity.

In the 1990s, open access moved downstream. A series of FERC rulings allowed large users to arrange their own transactions with producers and use interstate pipelines on the same terms as LDCs. Since FERC had given these customers new options, state regulators had difficulty cross-subsidizing small consumers by setting high LDC rates for industrial users. During the 1990s, regulators in most states with large industrial loads began to allow industrial consumers to transport their own gas purchases over LDC lines, replacing regimes in which LDCs acted as full-requirements resellers of gas to all of their customers. In at least one major metropolitan area, Atlanta, households now have a choice of gas marketers who will sell to them.

With the end of price controls the shortage of gas vanished. In real terms, the average annual wellhead price of gas peaked in 1984, when price controls were still in effect. (Regulators had raised them on several occasions following the 1973 energy crisis.) It then fell almost steadily until 1998, when it reached 46 percent of the 1984 level. After 1998, it began rising to a 2001 high equal to 89 percent of the 1984 level.4 Instead of falling with supply exhaustion, U.S. gas consumption rose by 25 percent between 1984 and 2002.5 As economists would predict, during the 1984–1998 period of declining prices, reserves fell to 85 percent of their 1984 levels. Over the higher-price years 1998–2002, they then rose by 13.8 percent with increased exploration and drilling.6 Demand for gas is growing with the invention of new, environmentally clean technologies. Most important, the development of relatively small (under 200 megawatts), fuel-efficient gas-fired power plants has brought competition to the primary production of electricity in most parts of the country.

The shortages and politically determined allocations of gas that accompanied price controls are no more. Open access to pipelines and storage has brought about a nationwide market that is becoming continent-wide as Canadian gas is integrated into U.S. supplies. In the unified market, prices at different locations differ only by the cost of transporting gas between them, as long as pipeline capacity is not a constraint due to severe weather. Most gas is traded in short-term markets for delivery during the next month. Long-term contracts and large storage capacities were necessary when price controls created risk that the gas would not be delivered, but now both gas and its transportation are available on short notice. The market price of gas is more volatile than that of any other major commodity. To hedge it, a wide variety of financial derivatives is now available, many based on the New York Mercantile Exchange’s futures contract, a highly successful instrument introduced in 1990. Over-the-counter derivatives also allow hedging of regional price differences and transportation costs.

As natural gas becomes more widely used, the low prices of the 1980s and 1990s may be vanishing. Those low prices were the favorable result of two countering forces. First, advances in drilling technology and seismic imaging sharply raised the probability that a newly drilled well would contain gas. Second, more attempts to find gas were successful, but by the 1990s, most legally accessible areas had been well probed. New wells were likely to be marginal and subject to quicker rates of production decline. As noted above, this does not indicate that the nation is “running out” of gas. Newly found reserves exceed current production, but gas will be more costly to extract from them. Environmental concerns have closed substantial parts of the country (including offshore areas) to exploration, despite evidence that gas production is compatible with the preservation of many natural environments. Gas imports from southwestern Canada have replaced some of the production decline, but that area is unlikely to contain undiscovered major fields.

Gas deposits elsewhere dwarf North America’s, which has only 3.3 percent of the world’s currently known total (and even less that can be reached cheaply). The coming alternative is liquefied natural gas (LNG), which can be economically transported across oceans in special tankers. LNG has been supercooled to −260°F, turning it into a liquid whose volume is 1/600 that of gas at atmospheric pressure. The LNG is offloaded to onshore storage facilities and sent into pipelines as necessary. LNG technology has existed for decades but has been little used because most consuming nations, until recently, had pipeline access to economical supplies. The conspicuous exception is Japan, which imports nearly all of its gas (nine TCF per year) as LNG through eighteen onshore terminals. Indonesia is currently the largest LNG producer, reflecting its proximity to Japan.7

Only 4 percent of world gas consumption currently moves as LNG, and LNG imports account for only 1 percent of U.S. use. The market, however, is rapidly expanding. As of December 2003, 151 LNG tankers were operating and 50 were under construction. A single tanker can carry 5 percent of the U.S. average daily consumption. The United States has four LNG terminals in operation or operable, and rising domestic prices have brought at least twenty credible proposals for additional ones. Twelve nations (including Qatar, Algeria, and Trinidad and Tobago) currently export LNG. Australia, Russia, Norway, and Egypt are constructing facilities, and numerous others will probably soon join them. The geography and politics of world gas markets will differ from world oil markets, a situation of particular interest because oil and gas are substitutes in many uses.

Because all aspects of LNG require specialized facilities, long-term contracts with inflexible prices dominate this stage of its development. Already, however, 8 percent of LNG is in short-term markets with flexible prices (often linked to oil prices), a figure that will grow with market liquidity and the development of tools for risk management. Like oil, gas will be monetized, and paper trades will supplement physical exchanges. Deliverability will be market responsive because LNG carriers, unlike pipelines, can change destinations in real time. In as little as ten years, we may see a single world price for gas, one hallmark of an efficient and competitive market.