CHAPTER 12 STATE NON-UTILITY REGULATION OF NATURAL GAS PRODUCTION, TRANSPORTATION AND MARKETING

• Jurisdiction: United States

Natural Gas Marketing
(May 1987)
CHAPTER 12
STATE NON-UTILITY REGULATION OF NATURAL GAS PRODUCTION, TRANSPORTATION AND MARKETING
Richard J. Pierce, Jr. ^*
Southern Methodist University School of Law
Dallas, Texas

I. INTRODUCTION — THE PROBLEM

Natural gas producers are pleading with state legislators and regulators to "do something" to solve the problems that have arisen over the last few years. By now, those problems are familiar. The deliverability surplus, combined with pipeline contractual obligations to purchase large volumes of gas at prices above the market-clearing level, has resulted in considerable shut in production. Widely varying production and take levels from common pools yield widespread and sometimes chronic violations of correlative rights. Conservation problems arise where shut in of oil well gas forces producers either to flare the gas or to shut in the oil. The monopsony power of purchasers in some fields leads to discriminatory purchasing practices.

Most rocky mountain states do not have in place the comprehensive regulatory programs long used by the older producing states to address the present range of problems.¹ Texas, Oklahoma, Louisiana and Kansas have had in effect for over fifty years integrated programs of regulation of allowable production levels and of purchasing practices that are intended to solve precisely the problems that adversely affect gas producers in the rocky mountain states in present market conditions.² It is sensible for producers, legislators, and regulators in the rocky mountain states to look first at the efficacy of these mature regulatory programs in their search for solutions to the present problems.

II. TEXAS — A TYPICAL INTEGRATED REGULATORY PROGRAM

A. The Mechanics of State Regulation

I will use the regulatory program established in Texas Railroad Commission (TRC) Rules 28, 30, 31, and 34³ to illustrate the goals and effects of an integrated state program of regulation of production and purchasing practices. Those rules reflect each component of a typical comprehensive system. The rules were revised most recently in February 1987. From time to time I will also refer to the rules in effect in Kansas, Oklahoma, Mississippi, and Louisiana to illustrate points that cannot be made exclusively through reference to the rules in effect in Texas.

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1. Regulation of Production

TRC determines market demand for each "pipeline system" by receiving nominations from each "first purchaser" that intends to purchase gas to be transported on that system.⁴ The nominations must be apportioned ratably among the fields from which the purchaser obtains gas for transportation on the system.⁵ Nominations must be made in accordance with a schedule of six priorities that starts with casinghead gas produced from tertiary recovery projects, extends through other casinghead gas, and concludes with gas well gas in the lowest priority.⁶ TRC then determines the market demand for each reservoir based on the nominations received, and establishes an allowable level of production for each well.⁷

The allowable set for each well does not constitute a self-implementing limit on the volume of gas that can be produced from the well, however. Rather, a producer is free to produce above the allowable level, subject to TRC's balancing rules.⁸ Semi-annually, TRC calculates the accumulated production above or below the allowable level for each well. A well that is overproduced consistently for two consecutive balancing periods can be ordered shut in. Underproduction can be carried forward from one period to the immediately following period. A well that is underproduced for two consecutive periods is limited to an allowable in the subsequent period no greater than the highest monthly production from the well during the prior period. The allowable assigned such a well can be restored to its normal level if the operator certifies that it is producing at a level above the limited allowable assigned it. Moreover, underproduction from a period before the immediately preceding period can be carried forward to subsequent periods if the operator submits evidence of increased demand that will permit it to balance through production above its normal allowable in subsequent periods.

2. Regulation of Purchasing

In addition to the elaborate rules governing production levels, TRC administers detailed rules that purport to control the conduct of gas purchasers. TRC considers these rules an integral part of its comprehensive regulatory program and essential to its ability to further the goals underlying its rules regulating production levels.⁹ Purchasers must purchase in accordance with the same six category schedule of priorities that applies to the nomination process.¹⁰ A purchaser is prohibited from purchasing any gas in a lower priority unless it is purchasing all the gas available in all higher priorities. Within each priority it must take ratably from each well, as well as from each field from which it purchasers. Moreover, if a pattern of underproduction and overproduction develops among wells in a field, the purchaser must adjust its purchases to

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restore ratability among wells, and a purchaser may not reduce its level of purchases from an underproduced well until all gas wells connected to its system are ratably reduced to the level of the allowable assigned the underproduced well. Significantly, however, none of TRC's rules are intended to abrogate contracts.¹¹ Thus, a purchaser must comply simultaneously with the obligations imposed on it by its contracts and by TRC's rules.

B. The Goals of Regulation

1. Exercise of Cartel Power

At various times and in varying contexts, TRC's rules have furthered four different state purposes. One clear purpose and effect of market demand proration (though it has never been officially acknowledged and has often been officially denied) was to permit the state to exercise the power it once possessed to enhance its wealth and that of its producer-citizens by reducing artificially the quantity of gas (and oil) it made available in order to increase the price of oil and gas in the United States. From the 1930's until sometime in the 1960's, Texas possessed considerable market power in the U.S. oil and gas market. The U.S. market was insulated from foreign competition by import quotas. Texas accounted for 47.8% of total U.S. oil reserves in 1961-63 and 54.8% of total reserves in 1949-51 — enough to confer upon it considerable power to affect oil prices through its output decisions.¹²

There is also powerful evidence to support an inference that Texas colluded with Oklahoma and Louisiana in making its output decisions during this period of several decades. The three states together accounted for 74.8% of total U.S. reserves in 1961-63 and 78.5% of total reserves in 1949-51.¹³ The percentage of market demand each of the three states allowed to be produced was remarkably similar for decades. In 1965, for instance, the percentage of market demand the three major producing states allowed to be produced was 29, 33, and 27, for Texas, Louisiana, and Oklahoma, respectively.¹⁴ In other words, these three states were the U.S. version of the OPEC cartel of the period from about 1930 until about 1970, and their main tool for implementing cartel pricing policies was coordinated proration of production based on a percentage of market demand.

To the dismay of many members of the industry, this purpose no longer can be furthered by state regulation of production. Its viability is dependent upon many factors, including the ability of producing states to engage in collusive regulation and the ability to insulate the domestic market from foreign competition. In today's market conditions, any reduction in production in one state would harm that state and its producers by displacing production and sales in that state with increased

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production and sales in other states.¹⁵ Even if several major producing states colluded to restrict production, each would be harmed, since their reduced output would be displaced by increased production from other countries. Thus, absent decisions by the federal government both to erect significant barriers to imported oil and gas and to acquiesce in collusion by producing states, this state purpose is only of historical significance.

2. Protection from Monopsony Power

The second state purpose that can be furthered by state regulation is to protect producers from potential exercise of monopsony power by pipeline purchasers. There are actually two somewhat different monopsony problems, which I will call monopsony I and monopsony II for convenience.¹⁶ Monopsony I exists because of economies of scale in transporting natural gas. These significant economies limit the number of pipelines that exist in or near a given reservoir. There is considerable evidence that monopsony I was a significant problem through the 1950's, with many reservoirs accessible only to one pipeline.¹⁷ That single pipeline was in a position to exercise its monopsony power by purchasing gas at prices below the market-clearing level. Moreover, since pipelines were subject to rate of return regulation, they had an incentive to discriminate in their purchasing practices in favor of their production affiliates in order to earn monopoly rents in a disguised form that escaped the attention of their regulators.¹⁸ The structure of the pipeline market has changed so much over the past few decades that monopsony I is not a problem in most producing areas — most producers have access to several pipelines.¹⁹ Still, there undoubtedly are some isolated areas in which monopsony I remains a significant source of concern.

Monopsony II has a different source. When a producer connects a well to a given pipeline and dedicates the underlying reserves to the fulfillment of a contract with that pipeline, it is subject to potential...