Natural Gas Prices-National and Regional Issues

By Kiesling, Lynne; Mattoon, Richard | Chicago Fed Letter, October 2003 | Go to article overview

Natural Gas Prices-National and Regional Issues

Kiesling, Lynne, Mattoon, Richard, Chicago Fed Letter

Why are U.S. natural gas prices currently at the high end? What are the implications of recent regulatory changes and changes in market fundamentals? This article explains the boom and bust nature of natural gas prices and some ways to reduce this volatility going forward.

Current natural gas prices in the U.S. are high-more than double their historical trend over the last five years-and futures prices indicate that natural gas supplies are likely to continue to be tight for at least the near term. High and volatile fuel prices are the consequence of both changing market fundamentals and regulatory decisions. Accordingly, the interplay of these effects could have substantial consequences, both nationwide and in the Midwest.1 This Chicago Fed Letter describes conditions that have put pressure on gas prices and suggests some potential strategies that might mitigate gas price volatility in the future.

Domestic market

Natural gas markets have been deregulated for the most part since the late 1970s, when the Federal Energy Regulatory Commission first allowed competitors to enter the natural gas pipeline industry. This deregulation movement broke the vertically integrated structure of the natural gas industry, which had arisen from federal interstate regulation dating back to early in the twentieth century. Deregulation opened up previously unrealized value creation opportunities that benefited most consumers and some producers. As a result, by the 1990s natural gas was widely available at very low prices, so low, in fact, that some producers went out of business or confined their extraction to existing deposits. Low prices reduce exploration, and high prices encourage it, resulting in a boom and bust cycle, which has historically been a feature of the industry.

Another development that has followed deregulation in the natural gas industry has been the creation of liquid, sophisticated financial markets for natural gas. The development of a wide range of financial instruments has enabled risk spreading in natural gas markets. The resulting ability to hedge risk across time and across different market conditions has substantially decreased the volatility in natural gas prices associated with the boom and bust cycle that characterizes extractive industries like natural gas.

So, why the recent spike in natural gas prices? The price increase has been fairly sudden, but not unpredictable. In fact, natural gas prices have been edging up since the late 1990s. Still, while the current and expected price increases are the consequence of the interaction of demand, supply, and other forces that shape the market, supply issues seem to be a particularly important factor.

Many analysts and energy industry experts have, correctly, pointed to regulatory restrictions as the prime cause of the rigidity of natural gas supply. In particular, they argue that limitations on drilling on federal lands, in consideration of the environmental amenities attached to those lands, have greatly limited exploration options. Approximately 40% of known natural gas reserves in the U.S. are off limits to exploration and production.

Another potentially abundant source of supply is imported liquefied natural gas (LNG) from such places as the Middle East, Russia, China, West Africa, and the countries around the Caspian Sea. However, the industry still has some work to do to convince the U.S. public that long-distance transportation of LNG is safe. And, even if the industry succeeds in this effort, it then has to build the necessary infrastructure to facilitate LNG imports onshore. LNG off-loading and storage at port requires specific technology in the terminals. Few such terminals exist in North America, and they take a long time to build. Construction of new LNG terminals can take up to a decade, taking into account siting and environmental regulatory processes. Accordingly, LNG terminal construction and imported supply is a long-term, though important, response to the current market imbalance. …

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