For more than 40 years, natural gas pipelines were regulated as natural monopolies. Federal regulations (i) authorized a single pipeline to link a city market with a producing area, (ii) limited entry, (iii) controlled transportation tariffs and gas prices, and (iv) required gas pipelines to own the gas they transported. But, in 1985, a new form of organization was authorized. The Federal Energy Regulatory Commission (FERC) partially deregulated natural gas pipelines and permitted them to become transporters of natural gas rather than merchants. Pipelines were allowed to unbundle natural gas from its transportation and to offer pure transportation services to their customers.(1) This change dissolved the barriers to markets that were inherent in the merchant carrier pipeline system and, for the first time in more than 50 years, authorized competition as a mechanism for distributing natural gas.
This paper examines the emergence of the competitive national natural gas market. This market was made possible by regulatory changes and by the creation of new decentralized market institutions that replaced the merchant carriage system for coordinating natural gas and transportation over the vast pipeline network of the United States. The primary focus here is on the institutional changes that underlie the emergence of natural gas spot markets and on the evolution of markets and prices from 1985 to the present. Removing the barrier that mandated merchant carriage between gas buyers and sellers brought forth new markets where none had existed. In five years, the number of markets reporting spot prices--in step with the number of pipelines offering transportation--grew from a handful to more than 50. Spot markets now exist in every production field and at many points where major pipelines interconnect. The trading is almost wholly decentralized. There is no central market for natural gas, and the bidweek institution is the primary means of coordinating gas and transportation.
Institutional and empirical evidence shows that as more pipelines elected to transport gas, new markets opened, the network of pipelines became more strongly connected, and prices converged throughout the network. Over the six year period of sample spot prices, one can observe the convergence of gas prices at geographically separated points in the network as competition began to enforce the law of one price.
II. THE EVOLUTION OF NATURAL GAS MARKET INSTITUTIONS
The three sectors in the natural gas industry are production, transmission, and distribution. Natural gas pipelines transport gas between the production and the distribution sectors. Of the three possible forms of transmission service that pipelines could have offered--merchant carriage, contract carriage, or common carriage--regulation mandated their structuring as integrated merchant carriers who sold gas bundled with transportation (see Daggett, 1955 for a discussion of the various forms of carriage). This structure restricted competition and balkanized gas markets.
A. Merchant Carriage
During the 1930s, the natural gas industry was vertically integrated to a significant degree. In some cases, producers owned pipelines. In other cases, distributors owned pipelines and production facilities in the gas fields. Under the Natural Gas Act, Congress re-organized the industry as a system of separate merchant carrier pipelines divorced from production and distribution. Vertical integration was discouraged, entry was controlled, and pipeline tariffs and gas prices were regulated.(2) Pipelines were required to tie the sale of gas to its transportation and could not offer pure transportation to their customers. Pipeline customers, usually local distribution companies and large end users, could purchase only the bundled package of services that included gas acquisition, storage, and transmission. Two qualities of bundled service were offered: …