[An updated version of this article can be found at Natural Gas: Markets and Regulation in the 2nd edition.]
Natural gas is methane in underground deposits, produced by the same geological processes as oil. As a relatively abundant and clean-burning fuel, gas has been touted as a means for achieving energy independence and environmental cleanliness. The 19.1 trillion cubic feet of gas used in the United States in 1991 accounted for 24.5 percent of total British thermal units (BTUs) consumed. Households consumed 26.3 percent of delivered gas and electric utilities used 16 percent to produce power.
Underground reserves of gas are difficult to project meaningfully because the amount of gas worth discovering and exploiting depends crucially on its expected future price. Between the early sixties and the late seventies, federal regulations kept the price to producers low and discouraged exploration for new supplies. By the 1970-75 period annual additions to reserves had failed to keep pace with production, falling to less than half of their 1955-60 levels in the lower forty-eight states. With the decontrol of gas prices, which began in the late seventies, additions to reserves have stabilized and now roughly match production. Proved reserves are currently about ten years of production.
Before the development of high-pressure pipelines in the twenties, gas was either flared off as hazardous or consumed in the vicinity of its production. Today, interstate pipelines, usually owned by entities other than producers, link wells with consuming areas. Local distribution companies (LDCs), usually owned independently of pipelines and producers, deliver and sell gas to final users. Most distribution is by corporate LDCs, with the remainder by municipal governments. Two types of pipeline service are available to distributors. Under so-called sales, or system, supply the pipeline purchases gas from producers and resells the gas to the LDC. Under transport the LDC makes its own purchases directly from producers and uses the pipeline only as a transporter. Both sales and transport can either be firm (interruptible only in emergencies) or interruptible. Between 1984 and the first half of 1992, transport service grew from 4 percent to 87 percent of pipeline activity. More recently, some LDCs have also become transporters of gas purchased by their larger customers.
The markets faced by producers, pipelines, and distributors differ substantially. Because the average producer of gas is a small company—262,483 wells, owned by thousands of concerns, were operating in the United States at the end of 1989—production is intensely competitive. Because many gas fields are reachable by more than one pipeline and because pipelines are extensively interconnected, the buyers' side of the wellhead market is also competitive. Pipeline technology, however, has attributes of natural monopoly: the cheapest way to transport a given volume of gas is by a single pipeline. Furthermore, most consuming areas can be reached by only one or a very small number of pipelines. Because the cheapest technology for reliable local service is a single network of pipes under centralized control, distribution also has attributes of natural monopoly.
The regulation of the different stages of gas production is complex and has changed dramatically since the mideighties. Under the Natural Gas Wellhead Decontrol Act of 1989, the Federal Energy Regulatory Commission (FERC) ceased to regulate wellhead prices on Jan. 1, 1993. But in reality recent regulatory decisions and changes in market conditions made existing price controls irrelevant before that: prevailing market prices dropped below the maximum prices that the law allowed.
Interstate pipelines are also under FERC jurisdiction, whether they act as system suppliers or as transporters. Pipelines apply to the FERC for permission to set particular rates. The FERC then holds administrative hearings at which parties who are affected by the rates have legal standing to intervene and to question aspects of the application. Rates for each type of service and class of customer must cover the pipeline's cost of service, which is defined as "prudently" incurred expenses plus a "fair" rate of return on stockholders' equity. Neither prudence nor fairness is well defined, and pipelines and their customers may understandably differ over them. One reason for such differences is that when a facility simultaneously produces several services, there is no economically meaningful way of distributing its joint costs among customers. The inherent arbitrariness often leads some customers to allege that they are being forced to subsidize other customers.
State regulators set LDC rates by similar administrative procedures. Thus, competition effectively rules in the naturally competitive wellhead market, and regulation sets rates in the naturally monopolistic pipeline and LDC markets. The evolution of the gas industry is important both as history and as an illustration of the power of economic thinking to shape public policy. Only fifteen years ago, gas was a grossly misregulated industry. It reached its current, much-improved state as a result of legislation, regulations, and judicial decisions, many impelled by market forces that regulators could not control.
The Natural Gas Act of 1938 instituted pipeline regulation by the Federal Power Commission (FPC, reconstituted in 1977 as FERC) as a consequence of concern about monopoly. At the time, pipelines functioned only as resellers to LDCs of gas purchased from producers, and the FPC had jurisdiction over their resale rates. In its 1954 Phillips decision, the Supreme Court ruled that the commission also had jurisdiction over the prices at which producers sold gas to pipelines. The expansion in its regulatory task was tremendous: although there were fewer than a hundred pipelines, there were tens of thousands of gas wells. To make its task manageable, the FPC set ceiling prices by geographic areas, based on the premise that the cost of finding gas to replace exhausted wells would be about the same as exploration costs had been in the past.
As events unfolded, exploration costs rose dramatically, and a severe shortage of gas began to emerge in interstate commerce. However, because intrastate sales—sales of gas in the state where it was produced—were exempt from federal price controls, there was no shortage of gas in those markets. The FPC allowed some price increases in the interstate market, but these were not large enough to end the shortage. Faced with an obligation to deliver gas and a shortage at the wellhead, pipelines made "take-or-pay" contracts with producers, in which they obligated themselves to purchase certain amounts of gas. If they did not take the gas, they were still obligated to pay for the contracted amount.
As long as their LDC customers bought predictable amounts, the pipelines had a long-term asset (sales) that balanced a long-term liability (take-or-pay contracts). The predictability of LDC purchases, however, vanished in the midseventies. State regulators adjusted LDC rates so that industrial customers would bear relatively more of the burden of rising prices. These users responded by instituting conservation and fuel-switching capabilities, decreasing their consumption.
The Natural Gas Policy Act of 1978 (NGPA) attacked the shortage by a phased deregulation of wellhead prices. In the early eighties, however, the collapse of the world price of oil caused gas prices to fall as well. Supply and demand once again ruled, making the remaining price controls on natural gas largely irrelevant. Pipelines faced severe financial strains because take-or-pay contracts from the shortage period remained in force, committing them to purchase gas at higher prices than those at which they could resell it. They reacted by instituting "special marketing programs" (SMPs) to transport, rather than resell, gas to certain customers at discounted rates in exchange for forgiveness of take-or-pay obligations. In the 1985 Maryland People's Counsel cases, the U.S. Court of Appeals for the District of Columbia ruled that SMPs were unduly discriminatory, and that FERC would have to devise regulations that allowed all customers the option to use pipelines as transporters.
FERC devised such regulations, which were broadly approved by the same court in the 1987 Associated Gas Distributors case and some later decisions. Under them a pipeline could receive an "optional expedited certificate" for new service (thus bypassing a costly and tedious regulatory process) only if it agreed to be an "open access" transporter of gas for all customers who wished to switch from system supply to transport service. Take-or-pay obligations would be correspondingly credited. Within months every major pipeline had applied for and received open access status.
In April 1992, FERC Order 636 completed the transformation of the industry. Known as the Final Restructuring Rule, it mandates transportation "on a basis that is equal for all gas suppliers whether purchased from the pipeline or another seller." It requires the institution of "no-notice" transport service, liberalizes access to gas storage, increases a shipper's options to change receipt and delivery points, and increases downstream access to rights on upstream pipelines. The order reverses decades of inefficiency by requiring that a customer pay rates equal to the actual operating and capital costs that it imposes on the pipeline. Finally, a "capacity release" program requires each pipeline to set up an electronic bulletin board and to institute rules by which holders of unwanted transport capacity may take bids from others who wish to lease or buy it. Somewhat oddly, Order 636 imposes price ceilings on the resale of capacity; these controls could cause shortages (see Price Controls).
Despite economists' frequent criticisms of regulators and the courts, these were the prime forces that moved the gas industry from misregulation to competition. Converting pipelines into transporters allows customers the benefits of being able to search for attractive purchases, rather than obligating them to take whatever gas the pipeline chooses to buy. (The alternative of system supply remains.) Allowing customers to resell their pipeline rights further increases their options. The advent of open access transportation and a market in released capacity provided an important lesson in economics: although a pipeline is technologically a natural monopoly, a market is arising in which the services of that monopoly will be allocated competitively.
If LDCs can use pipelines as transporters, the next logical question is why final customers cannot use pipelines and LDCs to jointly transport gas for them. An industrial firm might buy gas from a producer, use an interstate pipeline to transport it to the city gate (currently legal), and then use LDC facilities for the final miles. Some state regulators have tried to prohibit such bypass of full LDC service, in hopes of perpetuating a rate regime in which industrial customers cross-subsidize residential customers. A growing number, however, now allow large users and associations of smaller users the option of using LDCs as transporters. An emerging gas brokerage industry now assembles groups of users, purchases their requirements from producers, and arranges for transport with pipelines and LDCs. Further limiting LDC powers, several U.S. appellate courts have, since 1989, ruled that state regulators cannot block residents from directly transacting with an interstate pipeline. As recently as 1988, FERC Chairman Martha Hesse called LDCs the only remaining islands of monopoly in a sea of competition. They may soon be submerged.
Robert J. Michaels is a professor of economics at California State University, Fullerton. He has served as consultant to gas producers and interstate pipelines.
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