REGULATION TO COMPETITION—THE U.S. GAS MARKET, 1954-1993
| Jurisdiction | United States |
(Feb 1998)
REGULATION TO COMPETITION—THE U.S. GAS MARKET, 1954-1993
Missouri City, Texas
Order 636, issued by the Federal Energy Regulatory Commission (FERC), on April 8, 1992 (III FERC Stats & Regs # 30939), followed by Order 636A (III FERC Stats & Regs # 30950) on August 3, 1992, and Order 636B (61 FERC # 61272) on November 27, 1992, affirmed United Distribution Companies v FERC, 88 F 3rd 1105 made a number of basic changes in the manner in which natural gas is marketed in the United States. This Decision, together with the Pipeline restructuring Orders which followed it, created the gas market which will be discussed throughout this Seminar.
Order 636 was, however, only the latest step in a long line of decisions, each of which was hard fought in the FERC and the Courts, which gradually moved the sale of natural gas by a gas producer for resale in interstate commerce from the tightly controlled and regulated concept of a utility "service", to the concept of a marketable commodity, the price of which is determined in an active and viable marketplace, instead of being fixed by legislative or bureaucratic fiat. To trace this history through these many stages would require much more than my time or your patience would permit. My challenge, therefore, is to try to give you a broad overview of the evolving gas market, and the manner in which an oil and gas lessee who discovered a gas well disposed of its product during the vastly different time periods which preceded Order 636.
MILESTONES
In its Opinion reviewing Order 436, (Associated Gas Distributors v FERC, 824 F 2d. 981, 993, 1987) the District of Columbia Circuit Court of Appeals listed these milestones in the history of regulation of the gas industry: (1) The enactment of the Natural Gas Act in 1938 (15 U.S.C. # 717 et seq.); (2) the imposition of FPC regulation on producer sales in interstate commerce in 1954 by the Supreme Court in Phillips Petroleum Co v Wisconsin (347 U.S. 672, 1954); (3) the passage of the Natural Gas Policy Act in November 1978 (15 U.S.C.A. #3301), and (4) Order 436, issued by FERC on October 9, 1985 (III FERC Stats & Regs # 30665,
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Regs # 30665, 1985). To these I would add the enactment of the Wellhead Decontrol Act on July 26, 1989 (15 U.S.C.A . 3331 et seq), and Order 636.
THE FIRST TIME PERIOD 1961-1971
For gas producers, regulation really began in 1961, with the advent of the Swidler Commission, the Statement of General Policy No 61-1, and the inception of the Area Rate Proceedings in the Permian Basin and Southern Louisiana. Between 1954 and 1961 the FPC attempted to regulate producer sales on an individual company basis, which was largely ineffective. For the decade from 1961 to 1971, the gas market, and the producer's role in it, was vastly different than it is today.
In this period, The gas supply in the continental U.S. seemed virtually inexhaustible. In December 1972 the American Gas Association estimated "proved" reserves in the U.S. at 266.1 trillion cubic feet, of which 31.5 trillion were in Alaska. In 1972, the annual production and consumption of gas reached 22.5 trillion cubic feet.
These reserves had been found by producers largely in the search for oil, and sold as a "waste" or by-product to interstate pipelines (which provided the only large scale markets, except for areas in Texas) under long term contracts at low prices, with the promise that the prices would escalate throughout the contract term.
Given these facts, the Swidler Commission, and the White Commission which followed it, decided that it need not be concerned about the relationship between the price the gas received at the wellhead and gas supply, and devoted its efforts to preventing Producers from receiving "windfall profits" by transferring the "economic rents" (i.e., an economist's term for increases in the value of assets brought about by inflation and changes in supply and demand, over and above return of costs and permitted profits) from the Producers to the Consumers of gas.
In addition to placing a "ceiling" on the price which the Producer could charge at the wellhead (which prevented the escalation of prices as provided by the producer contracts), the FPC created an unbreakable "chain", from Producer
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to Pipeline, from Pipeline to Distribution Company, and from Distribution Company to Consumer. The FPC fixed the prices on a cost plus return basis on the sales from Producer to Pipeline, and from Pipeline the Distribution Company, while the State Regulatory Agency fixed the price from the Distribution Company to the Consumer. The Natural Gas Act prohibited the "abandonment" of any of the sales regulated by the FPC without the FPC's permission, which was almost never granted in this time period.
The fatal flaw in this system was that as each Mcf of gas was produced, one less Mcf remained in the reservoir to be produced in the future. In order to continue to deliver even the same quantities of gas as in the past, the Producers must continue to invest capital to find and produce new gas reserves. These new reserves were to be found only in less accessible locations, greater depths, or smaller reservoirs than those already found. Thus the cost of replacing the reserves being produced was less than the price the producer was receiving for the gas he sold, and even less than the price permitted by the FPC for "new" vintage gas, set at a slightly higher level. The inevitable result was that new additions to gas reserves dropped below production, resulting in a steadily increasing "shortage" beginning about 1971.
During this period, FPC regulation did not affect sales by Producers to intrastate buyers which did not take the gas out of the State in which it was produced. Before about 1971, ample supplies and the competition of interstate buyers held the price down on the intrastate market. After about 1971, there was no longer enough gas to supply both markets, so the intrastate prices rose, while interstate prices remained subject to federal ceiling prices. As a result, Producers directed their sales, where possible, to the intrastate market, and the interstate market suffered a steadily increasing shortage. Gas produced from federal acreage in the OCS was all subject to FERC jurisdiction because of the wording of Section 2(7) of the Natural Gas Act, which defined "Interstate commerce" as "commerce between any point in a State and any point outside thereof", despite the fact that for most purposes the laws of the adjacent State applied to the OCS.
The impact of federal regulation on the Lessee/Producer's obligation to pay royalty on the gas sold in interstate commerce resulted in what to many was a strange and inequitable result. The initial case was J.M. Huber Corp v. Denman,
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367 F 2d 104 (5th Cir 1966), in which the Court held that the lessor was not bound by a gas sales contract entered into by his lessee, where his lease provided that the royalty was to be a percentage of the "market value" of the gas, and the lessee had entered into a long term contract for the sale of the gas without escalation clauses which required the price to increase as the value of the gas increased.
The Huber Case might have made sense in a free market for gas, where the lessee would be held responsible for his failure to correctly predict market trends and contract against them. But where the lessee had inserted escalation clauses to keep the contract price at the market, and the FPC refused to permit these clauses to operate, and imposed price ceilings, to allow the lessor still to ignore the gas sales contract and the price controls, and base his royalty on "market value", seemed grossly unfair to the Lessee/Producer.
Nevertheless, this was the conclusion reached by the Courts in this time period. In a case arising in the Hugoton field in Kansas, the D.C. Circuit in 1971 held that the gas sales contract entered into by the Lessee/Producer did not constitute a "sale" of the lessor's gas, as he had surrendered the right to sell his gas when he entered into the oil and gas lease, and that therefore the federal price ceilings had no impact on the price on which the royalty was based, as this was a matter of contract between the lessor and lessee, Mobil Oil Company v FPC, 463 F 2d 256.
The final bar of the trap closed on the Lessee/Producer with the decision of the Texas Supreme Court in Texas Oil & Gas Corp v Vela, 429 S.W. 2d 866, 1968. Dealing with oil and gas leases and gas sales contracts executed in 1933, even before the Natural Gas Act was passed, the Court held that the Lessor was entitled to have his royalty based on the "market value" of the gas, determined at the time the gas was produced, not when the gas sales contract was entered into, despite the undisputed fact that the Buyer under the contract was the only market for the gas at the time, and that the Buyer demanded a contract for the life of the lease.
A split of authority developed on the so-called "market value" cases, with Kansas and Montana following the Vela Rule, while Oklahoma (Tara Petroleum V. Hughey, 630 P 2d 1269) and Louisiana (Henry v Ballard & Cordell Corp, 418
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So 2d 1334) adopted a more liberal rule, holding that if the Lessee entered into a long term gas sales contract in good faith, and received the market value of the gas at the time the contract was entered into, that the royalty would be based on the contract price, not the increased market value at the time the gas was produced. [All of the twists and turns of the market value litigation will be dealt with by others later in this seminar; I mention it here to place it in historical context with FPC regulation during this time period.]
THE SECOND TIME PERIOD — 1971 TO 1979
The year 1968 was a watershed year for FPC regulation of Producer prices...
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