CHAPTER 9 NATURAL GAS MARKETING AND TRANSPORTATION—THE KEYS TO THE 1990'S
| Jurisdiction | United States |
(May 1989)
NATURAL GAS MARKETING AND TRANSPORTATION—THE KEYS TO THE 1990'S
Vinson & Elkins
Washington, D.C.
I. INTRODUCTION
For decades the natural gas industry was governed by suffocating rules that attempted to guide, check and recheck seemingly the every move of all participants in the industry. Over time, many of these rules came to be seen as counterproductive. Regulators and legislators came to realize that the consumer, the ostensible beneficiary of this regulatory regime, often suffered from both higher prices and less service than could be obtained from alternative, less intrusive modes of regulation. In response, over the last decade the Congress, the Federal Energy Regulatory Commission ("FERC" or the "Commission") and the courts have instituted a series of radical changes in the regulation of the natural gas industry. The new rules attempt to rely on free market forces, but only as an aid to regulation, not as its replacement. The old rules have not been completely scrapped. Remnants remain. There is, therefore, a continuing tension between the old and the new regimes which pervades the natural gas market as it gropes its way forward in a grand experiment in a "leashed" free market.
The author is deeply indebted to James D. Stanfield, a legal assistant in the Vinson & Elkins Washington office, for his assistance in the preparation of this paper.
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Consider, for example, the production of natural gas. Under the Natural Gas Act ("NGA"),1 producers were subject to price ceilings on their sales of natural gas in interstate commerce. These price ceilings, being generally unrelated to the producer's cost of doing business, engendered several harmful side-effects. For example, natural gas that could have been economically produced remained in the ground. Moreover, because no such ceilings constricted sales of gas in the intrastate market, there were times when gas was plentiful in the intrastate market while in short supply in the interstate market. Gradually, the true cost of the interstate price ceilings came to be realized. Congress responded in several ways. Most importantly, Congress enacted the Natural Gas Policy Act of 1978 ("NGPA"),2 eliminating some price ceilings and phasing out some others. The NGPA represents only a partial reliance on the self regulating mechanisms of the market, though. Some price ceilings on producers' sales remain.3
As old gas wells deplete and new wells are drilled, the percentage of gas sold that is still subject to price controls declines. In 1984, 95% of the year's 17.5 Tcf of domestically produced gas sales was subject to price controls. In 1988, this percentage had shrunk to 39% of 16.6 Tcf. The percentages of domestically produced and sold gas
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that was "effectively decontrolled" — either decontrolled or sold at prices less than the effective price ceilings — are even more telling: in 1984, only 29% of such gas was effectively decontrolled; in 1988, 94% was.4
Similarly, for half a century interstate pipelines have been subject to price ceilings. This form of regulation, known as rate of return or cost of service regulation, theoretically attempts to relate pipelines' prices to their cost of doing business. As with the price regulation of producers, it has come to be realized that rate of return regulation of pipelines exacts hidden costs to all the players in the gas market, including the pipelines themselves. In exchange for a quasi-guaranteed rate of return, pipelines traditionally were required to provide sales service to all customers in their service areas, even if service to a particular customer would be a money-losing proposition for the pipeline (and, therefore, to its other, profitable customers). To complete this system, it was often necessary to render the pipelines' customer list inviolate. Likewise, an LDC's customers were its own, not to be served by anyone else. A pipeline could not raid the customers of another pipeline or of an LDC. This traditional format has given pipelines and LDCs few incentives to control costs (and in fact specifically prohibited their abandonment of unprofitable customers), and may have given them a perverse incentive to increase their rate base in order to retain higher earnings.
Of late, FERC has decided to respond to these distortions by relying more upon free market forces to regulate interstate pipelines. These attempts have been severely hampered by the overhang of thorny problems and existing laws. Like Congress, FERC has decided to rely only partially on the free market as it threads its way out of the thicket of regulatory and business problems. A substantial portion of the business of the pipelines will still be regulated under even the most liberal of the "new
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FERC" scenarios. Rate of return regulation has not even begun to wither away (although, as noted below in Section III H, it soon may). Moreover, under certain circumstances producers and marketers must follow rules promulgated by FERC, report transactions to FERC, and request FERC's permission if they wish to engage in certain activities. Likewise, the LDCs often find themselves under the indirect control of the FERC. The FERC's grant of freedom has boundaries defined, and continuously redefined, by the FERC itself.
The Commission is often inconsistent in its implementation of the new, freer regulation, sometimes reverting to old habits. Frequently, the Commission ignores both the complexities of the industry it regulates and the laws controlling the gas industry, pretending the world actually approaches the simplicity of the economic models to which it has sworn fealty. Always the Commission is torn between two opposite urgings — the yen to regulate and control, and the desire to set the market free. This paper details steps the FERC has taken in its struggle to shift from the habits ingrained during a 50 year regulatory pattern and the implications of that shift for the marketing and transportation of natural gas.
II. THE PLAYERS AND THEIR ROLES
In order to describe the directions the natural gas market is taking, we must first delineate the players in the market, their roles and the goals they seek. Bear in mind that these distinctions are not ironclad. A player may act in more than one role.
The initial link in the natural gas chain, of course, is the producer, who develops natural gas resources at the wellhead. The gatherer and/or processor generally is a non-jurisdictional entity that collects gas from the producer through a network of low-pressure gathering lines, and may also process gas to remove water and impurities and compress gas for redelivery to pipelines. The marketer, a relative newcomer to the industry, takes title to gas supply obtained from producers and resells it to buyers, typically an LDC or end user, and may arrange for transportation on behalf of the
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buyer. Marketers sometimes act as brokers, arranging a sale by bringing together seller and buyer without actually taking title to the gas. Marketers and brokers come in all stripes, from independents to affiliates of LDCs, producers or pipelines, and from large to small. The pipeline, either interstate or intrastate, acts as a transporter of natural gas from seller to buyer. The pipelines' traditional role as marketers, or merchants, of natural gas—taking title and reselling—is being challenged by competition from other sellers. However, the pipeline in its merchant function still plays an important part in supplying many LDC needs. I will detail that policy evolution later.
The local distribution company acts as a retailer and transporter of gas to end users ranging from residential consumers to industrial and commercial customers. The traditional role of the LDC, too, is changing. The typical LDC's concerns include its ability, or inability as the case may be, to maintain its old customer base to support existing revenues while adding new sales customers and obtaining incremental transportation revenues. In their struggle, the LDCs must contend with the impact of Order No. 500's tendency to facilitate direct sale arrangements which "bypass" the LDC. The industrial user typically purchases large volumes of gas for its own consumption, and often possesses fuel-switching capability. Industrial users have increasingly purchased "direct sale" gas, i.e., directly from a pipeline, producer or marketer, rather than from an LDC. Increasingly important among industrial facilities as gas buyers is the cogeneration facility, which may function as a potential large buyer of natural gas under direct sale fuel contracts, as a producer of electric and thermal (often, steam) energy, and as a seller of electric energy at "full avoided cost" to utilities pursuant to the mandate of the Public Utilities Regulatory Policy Act of 1978 ("PURPA"). Other users may soon include buying cooperatives.5 The final key players,
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of course, are the omnipresent regulators, both State and Federal.
Entities in the natural gas market enter into contracts to meet goals determined by their functional and economic needs. Contracts range from long-term to spot. A long-term contract classically involves a pipeline as the purchaser, but these are evolving for broader use by LDCs and certain industrials. The primary objectives of long-term contracts are to provide gas supply in a predictable quantity at a predictable price, and to ensure cash flow in established amounts to the producer. Spot contracts are typically defined as lasting less than one year, although contracts with flexible pricing terms may be extended. Spot contracts provide flexibility to shift between alternate fuels and suppliers, allow market responsiveness to variations in price and supply, and enable producers to sell gas which would otherwise be completely or partially shut in.
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