CHAPTER 1 OVERVIEW OF THE NATURAL GAS INDUSTRY
| Jurisdiction | United States |
(Sep 1991)
OVERVIEW OF THE NATURAL GAS INDUSTRY
Director, Natural Gas Consulting, and Energy M & A Coopers & Lybrand
Houston, Texas
(713) 757-5276
The natural gas industry first developed on the consumer end, not the production end. In the late 1800's the first gas created and used was coal gas. It was developed by local distribution companies, mostly in the Northeast. And they were subjected to state regulation of their activities because they were perceived as monopolies.
That situation continued until the 1920's when everybody saw the large volumes of gas that were being developed associated with the giant oil fields in the Southwest U.S. Gas was being routinely flared in massive quantities in the Southwest. Because of this and since oil was the income source for producers, this gas could be bought for almost nothing, 2 or 3 cents per mcf it someone would just take it away.
Based on this cheap supply and a growing consumer market, the interstate transmission lines were built to move gas from the Southwest to the consuming areas. By now, people, particularly in the Northeast, where most of the political power resided, were accustomed to having natural gas regulated. Also, they adopted a circular argument. First, they said it was inefficient to have multiple pipelines serving one area, so for efficiency's sake, the number should be limited. However, if you limited the number they said, then you were granting them monopoly power. Everyone knows monopolists must be regulated. Therefore, pipelines must be regulated. Consequently, the passage of the Natural Gas Act in 1938. What is particularly unbelievable about this is that the NGA is now, with the recent passage of decontrol, essentially the major law of the land where gas is concerned. The fact that it is 51 years old and totally non-reflective of market conditions today is evidently not important to our legislators in Washington D.C. because they won't touch it. A little later I will touch on some recent court decisions where the FERC has been
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reversed in some of their orders because primarily of questions regarding their statutory authority under the NGA.
More on that later....
From 1938 until 1954 the markets for gas continued to expand and many new major pipelines were built. Producers were still giving their gas away at the wellhead which allowed this market expansion. Unfortunately, the people who believe all activities in our economy should be regulated, looked down the pipe and saw, heaven forbid, that producers selling to the pipelines were allowed to receive whatever the market would bear for the gas. Never mind that gas was still below 10 cents without any large increases on the horizon. Consequently, we had the famous Phillips decision from the Supreme Court in 1954 that subjected producer prices to the same just and reasonable standards the other regulated entities lived with in the natural gas industry.
That, frankly, didn't effect field prices very much, if at all, for quite some time. For example, in 1960 we had enough gas production capacity to take care of twice our annual demand. Things were pretty quiet in the 60's. Many producers preferred then to sell gas in the interstate market because the price was higher than in the intrastate markets, if they even existed in the area.
However, a situation was at work that would alter this tranquility ... producers weren't looking for gas, they were looking for oil, and almost all of the new gas being found was by mistake. Plus the low prices were stimulating demand.
Thus by the early 1970's, we had very little excess gas productive capacity...
It was at this point that natural gas began to act more like a commodity. Prior to this time, the price of gas had been so low and so stable, that it was priced in the market almost as a "service," not as a commodity. As it developed that gas was subject to the forces of supply and demand, with large price moves, it became apparent that gas was a commodity. While this was apparent to "reasoned" people in the early 70's, politicians and others with vested interests were able to delay the "commoditization" and full decontrol of natural gas for over
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twenty years. During the interim, the partly regulated, party decontrolled system was only efficient in one area — sending false market signals to the players in the industry.
The OPEC Oil Embargo occurred in 1973 and even that shock didn't convince the regulators that higher gas prices were necessary. They were more concerned that producers might make some additional profits off of old gas than they were about developing additional supplies. Thus the FPC, not exactly a bastion of prowess in either economics nor common sense, continued on setting just and reasonable rates for wellhead sales in interstate commerce. In the mid 1970's interstate prices for new gas was held to about $.52 per mcf ($.68 if you would prove you were a small producer). It wasn't that they liked small producers its just that they hated large ones.
Anyway, the interstate price was held below $.68 while intrastate prices were reaching $1.50. You don't have to be an economist to understand what happened, all the new gas that could be was sold intrastate and nobody wanted to dedicate gas to interstate markets. You also don't have to be an economic savant to understand that while surpluses of gas were developing in intrastate markets, shortages were developing in the interstate market. It was those shortages in the winters of 76-77 and 77-78 that led to passage of the 1978 NGPA. The eastern consumers wanted ( 1 ) to get their hands on the intrastate surplus, and (2) they wanted to have a level playing field in buying new gas. Of course their proposals initially were to put all gas under price controls. The issue stalled in congress while the prevailing concept developed that there was no new gas to be found anyway, so existing gas supplies had to be hoarded for residential and high priority users. A trade was finally worked out that eliminated the intrastate advantage and allowed excess intrastate gas to move to the intrastate market without being forever dedicated interstate.
In exchange for this, the producing state senators and congressmen were able to get higher prices for new gas in return and eventual decontrol for some gas. Chart 1 shows the major gas pricing categories included in the NGPA. Several seeds of change were planted in that bill that I will talk about later. These seeds would drive the gas industry to be more market based and competitive. One important seed was not planted, a change in our regulatory structure to accompany the new market orientation. Congress didn't have the political will to touch that issue then, either.
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Let's look at that regulatory structure and some of the totally perverse signals it sends to both the market and to the industry. First, as a regulated entity, which pipelines are, the way to make more money in your regulated activities is by increasing your rate base since earnings are essentially based on the amount of unrecovered invested capital. Thus, if you were efficient and built facilities at lower costs, you were rewarded with reduced earnings. Consequently, new and expensive gathering systems, pipeline expansions and projects were built at very high costs. In a market based industry, high cost systems are a drug that has to be absorbed. Also, another feature of our regulatory structure is that rates are set based on throughput with cost and profit recovery being fixed. Think for a minute about what that does! As volumes are increasing, which should send the market place a signal to at least look at, if not actually reduce demand, prices for the regulated service per unit actually go down, because the regulated costs are recovered over more volume. Conversely, as volumes decrease, which should normally encourage more demand, regulated rates actually go up, thereby discouraging demand.
Thus, we have a rate structure that encourages over investment, which leads to higher transportation and distribution rates and sends false signals to the market place. The only justification provided by regulators for that system is that "its always been that way." This makes it very hard for the gas industry to operate in a competitive fashion.
Also, the regulatory system of the gas industry was developed with the belief that the pipelines would be the only sellers of gas. The concept was that if you bought gas from the pipelines you and all other buyers were buying your "pro-rata" share of all gas supplies across all pipeline facilities. Thus, most services are charged for based on system wide averages, or what is referred to as "rolled in pricing." All gas prices are rolled in" and all customers pay the same average price. Gathering, processing, storage and pipeline facilities costs were "rolled in" and no customer or supply differentiation was made. Thus, expensive new facilities could be added to pick up marginal supplies because the costs were "rolled in" with older, more fully depreciated systems. This does not reflect the competitive world in which we now find ourselves.
Unfortunately, these perverse market signals have hurt everyone in the gas supply chain. Pipelines were encouraged to over invest in facilities and buy gas under contract at almost
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any cost for a period of time. Producers relied on the false price signals for incentive gas and over-developed the resource base. Continuing bankruptcies provide testimony to the results of believing that either legislators or regulators can protect you from the forces of the market.
With that regulatory discussion behind us, I want to go back to the NGPA and see what happened to the seeds that were planted.
First, ask yourself a question. How many of you believe that there was a national shortage...
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