Natural Gas in the Twenty-First Century

By Barcella, Mary Lashley | Business Economics, October 1996 | Go to article overview

Natural Gas in the Twenty-First Century


Barcella, Mary Lashley, Business Economics


The Natural Gas Industry, like the electricity industry, closes the century in the throes of revolution. The wellhead-to-burnertip regulation and control that characterized most of the industry's development in the twentieth century is being abandoned in favor of competitive mechanisms that have only recently become available to the industry. The latest advances in information and communications technology have made it possible to create "virtual markets," with electronic trading linking physical gas flows and financial transactions. The future of natural gas bears little resemblance to its past.

INDUSTRY STRUCTURE

Historically, the natural gas industry had a simple structure. Hundreds of gas producers sold their product to dozens of interstate gas pipelines, whose very existence was predicated on long-term supply contracts with these producers. Beginning in 1954, the price of gas in these transactions was federally regulated. Pipelines carried the gas to local consuming markets where they sold it at the city gate to a local gas distribution company (LDC), which performed the final distribution and sale to end users. The city gate price was dictated by the pipeline's regulated tariff, while the prices paid by end users were typically set in the LDC's tariff by state regulators.

Federal and state regulation of pipeline and LDC rates and operations were justified on natural monopoly grounds. Technologically, the cost of a pipeline is roughly proportional to its diameter, while its volumetric capacity increases with the square of its diameter. This results in declining average costs as pipeline size increases. LDCs are similarly characterized and, of course, were the textbook example of natural monopoly in John Stuart Mill's Principles of Political Economy. Pipeline and LDC rates were set on a cost-of-service basis, covering "prudently incurred" costs, including an allowed rate of return on capital stock. Rate setting was a quasi-judicial process, with rate proposals presented by company lawyers, challenged by customers or their representatives, and adjudicated by regulatory commissioners. Rates were to be "just and reasonable," as opposed to economically efficient. Where possible, social or political objectives were also pursued, such as cross-subsidies favoring residential customers.

While the justification for pipeline regulation has come under fire in recent years from some quarters,(1) the organization of the pipeline industry as a regulated natural monopoly may well have been efficient, given the existing technology.(2) In a world of vacuum tubes and operator-assisted rotary-dial telephones, long-distance pipelines served to communicate and modulate supply conditions at one end of the pipe with demand conditions at the other.

Conditions are different today. High-speed communications and information technology make it possible for a single market to process millions of transactions a day. Information on market conditions across the country is readily available to any interested parties. Pipelines are only needed to deliver gas.

As a result of these innovations, wellhead gas sales are today completely competitive. Most sales are made on spot markets, where prices are highly transparent. Spot prices are converging across regions, a development that has been attributed to the increasing ability to move gas from one region to another under open-access pipeline transportation arrangements.(3) Pipeline capacity is traded in a partly deregulated, increasingly competitive environment. Local distribution services are increasingly being "unbundled" (i.e., separated) from gas sales and provided on an open-access basis. A new industry segment - natural gas marketing - has developed to arrange gas purchases and deliveries for many LDCs and end users. These marketers, as well as some producers, LDCs and end users, use natural gas futures, options, swaps and other financial instruments to hedge their financial risks and/or as an alternative to gas storage in their supply portfolios.

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