Purchasing Strategies for Natural Gas in a Deregulating Market

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Purchasing Strategies For Natural Gas In A Deregulating Market

The market for natural gas is in the continuing process of deregulation. As this process progresses, it changes the cost effectiveness of various purchasing strategies for large-scale users. This article outlines the direction of the deregulation movement and suggests an approach that buyers can use to adapt to the changing market environment.

INTRODUCTION

The rapidly changing regulatory environment for domestic natural gas, combined with current excess deliverability, provides an opportunity for large-scale industrial users to achieve substantial cost savings. However, decreases in delivered gas costs can only be obtained through a much more aggressive purchasing policy than has been common for this commodity in the past. New policies must sweep away dated conceptions of natural gas as a "utility" that can only be purchased from a local distribution company (LDC) that has a regional monopoly. Purchasing strategy must consider the strong forces that are moving the market in the direction of competition and, when possible, enhance them to maximize potential cost reductions.

This article examines the regulatory and business environments surrounding natural gas from a managerial perspective, discusses purchasing and managerial implications, examines the purchasing objectives of large industrial consumers, and offers some general suggestions that should be helpful in achieving the objectives.

THE REGULATORY ENVIRONMENT

Historically, the natural gas market has been tightly regulated by both state and federal agencies. The justification for this control has been that: (1) natural gas is a necessity, implying that consumers have little capability to utilize substitute commodities, and (2) the production and distribution of natural gas can sometimes result in the generation of excess profits, an element economists refer to as economic rent.

Economic rents can occur whenever the potential price of a commodity substantially exceeds its actual cost of production, including a reasonable return on investment. Government regulators tend to view these rents as a question of income distribution. They ask, should these rents accrue to consumers in the form of regulated prices that are below the potential market price, to producers in the form of excess profit, or to citizens in general in the form of reduced taxes? Natural gas regulation prior to the Natural Gas Policy Act (NGPA) of 1978 favored consumers with prices that were held at arbitrarily low levels. As might be expected in a market where prices were held below market levels and a great deal of unutilized capacity existed, natural gas usage increased rapidly. This was especially evident following World War II. Improvements in pipeline technology contributed to the market glut by allowing distant producers to gain access to the major urban consumption centers. An unanticipated result of this long period of regulation was that incentives for exploration declined dramatically. This phenomenon ultimately allowed the growth in demand to overtake the margin of unutilized capacity. By the late 1960s the nation's reserves began to decline, and the critical "reserve to production" ratio fell rapidly.(1) These data are shown in Figure 1.

The NGPA addressed this emerging supply shortage by recognizing the value of allowing market forces to set natural gas prices at the wellhead. The period since 1978 has seen wild gyrations in both the price and supply as the newly decontrolled market has sought to establish a sustainable equilibrium. The economic rent issue - where the dollars generated by this market process will ultimately reside - is still largely undecided. However, mounting evidence suggests that aggressive consumers can obtain a large share of the proceeds if they can maximize the actual and potential competitive forces that exist in the marketplace. …