Privatesector P U B L I C P O L I C Y F O R T H E Note No. 141 April 1998 Development of Competitive Natural Gas Markets in the United States Andrej Juris The United States enjoys a highly competitive natural gas market and an increasingly efficient market for pipeline transportation. Consumers have benefited from changes to both the structure and regulation of the industry in the past ten to fifteen years. These changes have lowered natural gas prices and broadened the range of services offered by gas companies. This Note reviews the forces driving the regulatory changes and the effects of the changes on the functioning of gas markets. It also provides an overview of natural gas trading mechanisms in the United States. The focus is primarily on the wholesale natural gas market, the market most affected by deregulation. Deregulation of the gas industry when the Natural Gas Act established a basis for regulating the prices and activities of gas The U.S. natural gas market is the world’s largest, companies. Over the next forty years regula- with a total supply in 1996 of 25.6 trillion cubic tion gradually increased its reach as new regu- feet. About 75 percent of this supply is pro- latory institutions and policies emerged. duced domestically, with the balance from stor- Interstate transactions came under regulation age withdrawals and imports (12 percent each). by the Federal Power Commission (FPC), later Gas production is concentrated in the South, succeeded by the Federal Energy Regulatory along the Gulf Coast in Louisiana and Texas, Commission (FERC), while intrastate transac- and in smaller producing regions in Alaska, the tions were regulated by state agencies. Southwest, and the central United States. But most natural gas consumers are in the North- Overregulation east, the Midwest, and the Pacific Coast region, all areas where imports of Canadian gas play an By the 1970s regulatory agencies controlled important part in meeting demand. The geo- almost all aspects of business in the industry. graphic imbalance between producers and con- Regulation was applied not only to industry sumers means that large quantities of natural segments dominated by natural monopolies, gas must be transported long distances across such as pipeline transportation, but also to com- the country and the continent. So even small petitive segments, such as production and inefficiencies in production or transportation of wholesale supply. The excessive control bur- natural gas can have a large economic effect on dened companies and distorted natural gas the gas industry. prices and consumption patterns. The U.S. natural gas industry has gone through Excessive regulation of gas producers, for a full cycle of government regulation in the example, led to gas shortages in the 1970s.1 In past sixty years. During the first several decades the 1950s the FPC had started to regulate prices of the century the industry enjoyed limited over- at the wellhead where interstate pipeline sight by the government. That changed in 1938, companies purchased natural gas from The World Bank Group ▪ Finance, Private Sector, and Infrastructure Network 2 Development of Competitive Natural Gas Markets in the United States producers. But with hundreds of active well- to supply contracts concluded after 1975. Supply heads in the country, the commission was un- contracts concluded earlier were priced at low able to process all the tariff applications. By historical tariffs. Since interstate pipelines had a 1960 it had completed 10 out of 2,900 applica- large portfolio of old gas contracts, the average tions. It was forced to adopt an “area rates” wellhead costs of natural gas were well below approach, setting a uniform tariff for all pro- the economic value. Consumer demand was ducers in the same geographic area. Although therefore much higher than it would have been this step decreased the number of tariff cases, in a competitive market. This aggravated supply the approval process was still very slow, aver- shortages. The costs of gas shortages in the 1970s aging ten years per case. were estimated at US$2.5–5.0 billion a year. The area rates were based on average historical Deregulation costs of production. These averages became very low relative to the increasing costs of produc- Gas shortages prompted deregulation in order tion in the 1960s and early 1970s. Producers to promote efficiency in production and bulk found sales of natural gas to interstate pipelines supply of natural gas. The main approach was unprofitable and curtailed gas supply to the in- to allow free competition among producers and terstate market. They found it more profitable suppliers in the wholesale gas market. The pro- cess was launched in 1978 when Congress adopted the Natural Gas Policy Act, authoriz- Even small inefficiencies in production ing the FPC to liberalize interstate natural gas markets. The FPC adopted a number of regu- or transportation of natural gas can latory measures that partially liberalized well- head prices of gas, allowed competition in the have a large economic impact on the wholesale gas market, and enhanced regula- tion of interstate gas pipelines. Congress gas industry. adopted additional legislation in 1989 and 1992 further liberalizing wellhead gas prices and in- terstate natural gas transactions. to supply gas to the intrastate market in Texas or Louisiana, for example, where wellhead prices Among the most important measures adopted were unregulated or considerably higher than by the FERC was Order No. 436 of 1985, which in the interstate market. As a result interstate introduced open access to interstate pipeline pipelines faced shortages of gas supply and con- transportation and limited the use of long-term sumers in the Northeast and Midwest experi- contracts. Local distribution utilities and large enced supply interruptions. end users were allowed to purchase natural gas directly from producers, bypassing inter- To attract producers back to the interstate mar- state pipeline companies. Companies that ket, the FPC adopted new regulation in the mid agreed to provide open access to their interstate 1970s. A uniform national wellhead tariff was pipelines were allowed to charge an open ac- set at an average of current and expected costs cess tariff, regulated by FERC, for provision of of gas production, leading to a quintupling in transportation services. To promote competi- wellhead prices. However, the new regulation tion in the bulk supply of natural gas, FERC did not eliminate the main cause of gas short- allowed gas marketing companies to arrange ages—the regulation itself. Average cost–based purchases and sales of natural gas on behalf of national tariffs seldom reflected the true eco- other industry participants. nomic value of natural gas as it would be set in a competitive market. And even if national tar- Deregulation of the gas industry followed when iffs did reflect economic value, they applied only FERC adopted Order No. 636 of 1992, which The World Bank Group 3 FIGURE 1 TRADITIONAL STRUCTURE OF THE U.S. GAS INDUSTRY, BEFORE 1985 Pipeline Distribution Producers companies companies End users Gas transportation Gas sales FIGURE 2 OPEN ACCESS TO PIPELINE TRANSPORTATION, 1985–92 Residential Distribution companies Commercial Pipeline Producers companies Industrial Wholesale market Marketers Electric utilities Gas transportation Gas sales FIGURE 3 UNBUNDLING OF GAS SALES FROM PIPELINE TRANSPORTATION, 1992 AND BEYOND Residential Distribution companies Commercial Pipeline Pipeline Producers companies companies Industrial Marketers Electric utilities Spot market Gas transportation Gas sales 4 Development of Competitive Natural Gas Markets in the United States required the interstate pipeline companies to distribution companies and final consumers, unbundle natural gas sales from pipeline trans- since regulators allowed a pass-through of gas portation by setting up separate affiliates to purchase costs to consumers. Order No. 436 handle these activities. This removed an incen- allowed distribution companies to exit these tive for interstate pipeline companies to dis- long-term supply contracts with pipeline com- tort bulk supply competition through restricting panies and purchase natural gas directly from access to pipelines. producers. But pipeline companies were not allowed to exit their contracts with producers To minimize distortions in the gas market caused and so were left with large contractual obliga- by regulated prices for interstate pipeline trans- tions that they were unable to meet. The pipe- portation, Order No. 636 also enhanced the line companies challenged the order in court, method for calculating transportation tariffs and and FERC had to issue a new order (Order No. introduced a program for the resale of firm trans- 500 of 1987) allowing the companies to pass portation contracts. This program, the capacity on up to 75 percent of the transition costs to release program, allows shippers (any users of producers, distribution companies, and large pipeline transportation) to purchase pipeline ca- consumers. Only then did the interstate pipe- pacity from shippers that have temporary or per- line companies begin to implement the open manent excess reserved capacity. The capacity access regime on a large scale. release market promotes the efficient allocation of transportation contracts among shippers and Order No. 636 completed the deregulation of allows gas market participants to match trans- the wholesale gas market by liberalizing entry portation contracts to their gas supply contracts. into gas marketing. It was followed by a series of FERC orders to promote competition in the The two orders dramatically changed the op- wholesale gas market and increase flexibility eration of the gas industry, from tight regula- in interstate pipeline transportation. FERC is tion to free competition in the wholesale gas now focusing on developing short-term capac- market. But implementation of the orders ity resale and standardizing gas supply and imposed large transition costs on some industry transportation contracts. participants, which naturally opposed changes. Opposition to Order No. 436 was particularly Impact strong. The transition costs related to Order No. 436 were estimated at US$11.7 billion in 1986, Deregulation has changed the structure of the half the total book value of interstate pipelines U.S. gas industry. Until 1985 the industry was in 1984, at US$23.4 billion. The actual value of vertically separated into production, pipeline transition costs was $10.2 billion as of 1995.2 transportation, and distribution (figure 1). How- Only after FERC worked out a mechanism to ever, all transactions were tightly regulated and distribute the costs among all industry partici- completed under long-term contracts. The in- pants could the orders be successfully imple- troduction of open access to interstate pipe- mented and competition flourish. line transportation in 1985 gave rise to the competitive wholesale gas market, and gas mar- The costs arose in the following way. Before keting emerged as a new segment of the in- 1985 interstate pipelines entered long-term sup- dustry (figure 2). The unbundling of interstate ply contracts to purchase from producers and pipeline transportation completed the whole- sell to distribution companies. Many of these sale market’s transformation into a fully com- contracts were concluded at very high well- petitive market in 1992 (figure 3). head prices, which pipelines, fearing a recur- rence of the supply interruptions of the 1970s, The liberalization of gas marketing and whole- were willing to pay. The uneconomic costs of sale gas prices attracted many new companies gas purchases at the wellhead were borne by into the wholesale gas market. The fierce com- The World Bank Group 5 FIGURE 4 AVERAGE NOMINAL NATURAL GAS PRICES IN THE UNITED STATES, 1984–95 U.S. dollars per thousand cubic feet 7 7 6 6 Residential 5 Commercial 5 4 4 Industrial 3 3 Electric utilities 2 Wellhead 2 1 1 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 Source: Energy Information Administration, Washington, D.C. petition that ensued among marketing firms and The functioning of a competitive gas producers increased the pressure on whole- gas market sale gas prices. The price competition benefited not only wholesale market participants, but also After fifteen years of deregulation, the whole- final consumers of natural gas. Nominal prices sale gas market in the United States is fully of natural gas decreased or remained stable for liberalized and very competitive. Producers, all consumer categories after 1985 (figure 4). pipeline companies, marketers, distribution This meant a substantial decrease in real prices. companies, and large consumers trade natural Wellhead prices dropped on average 26 per- gas in a large number of regional markets. cent in real terms between 1988 and 1995, while Natural gas transactions are mostly arranged prices at city gates (the entry points to pipeline by gas marketers, which buy and sell natural networks for local distribution) fell by 24 percent. gas on behalf of producers, distribution com- panies, and large consumers. Most trading takes Although there was an overall decline in retail place in spot markets at major market centers gas prices, the distribution of benefits was un- and hubs on interstate pipelines (figure 5). even. Large consumers such as electric utilities Important trading activity also occurs in finan- and industrial consumers, which now purchase cial gas markets (futures and options), where about 75 percent of their gas requirements in participants minimize the price risks in natural the competitive wholesale market, saw a 26 to gas spot markets. And recently electronic trad- 31 percent decline in real prices between 1988 ing systems have developed that allow the and 1995. Most small consumers, however, are trading of natural gas and pipeline capacity in still captive to local distribution companies, and all major markets in the United States and only about 25 percent of gas consumed by com- Canada. mercial users is purchased directly in the whole- sale gas market. As a result, commercial and Gas marketers residential consumers saw only a 12 percent decline in the average real price of natural gas Gas marketing companies are a dynamic and between 1988 and 1995. competitive segment of the U.S. natural gas 6 Development of Competitive Natural Gas Markets in the United States FIGURE 5 TRADING IN MARKET CENTERS AND HUBS Pipeline Pipeline company company Producers Distribution companies Spot market Large Marketers end users Pipeline Pipeline company company Pipeline capacity transactions Natural gas transactions industry. The share of deliveries they arrange As natural gas markets have become increas- increased from 20 percent of the total in 1987 ingly complex, marketing companies have to 49 percent in 1995. The first marketing com- sought to expand their size and scope in order panies emerged in the late 1980s, but the main to accommodate the diverse needs of their cli- boom occurred after implementation of Order ents. In 1995 and 1996 a wave of mergers in- No. 636 in 1992, as producers, pipeline com- creased the concentration of sales. In 1994 the panies, and distribution companies formed top ten marketers arranged average daily sales marketing subsidiaries to take over natural gas of about 31 billion cubic feet of natural gas, 42 acquisition and sales. percent of total U.S. daily consumption. In 1996, after mergers between several large players, Marketing companies benefit other participants the top four marketers alone accounted for this in the gas market by minimizing transactions volume of sales. Despite this concentration, costs and supply and price risks. They group small marketers continue to play an important the supply and demand needs of market role, particularly in local markets, which are participants and match them with appropriate commercially unattractive for major players. contracts on a large scale. This intermediation reduces the costs of transactions by freeing buy- Hubs and spot markets ers and sellers from having to shop for the best contract. At the same time, by aggregating con- Over the past ten years natural gas transactions tracts, marketers can diversify the supply and in the wholesale market have gradually moved price risks of individual contracts. These risks from wellheads to hubs at major interconnec- often arise when market participants with dif- tions of interstate and intrastate pipelines. Today ferent supply and demand characteristics try most gas trading in the United States takes place to arrange transactions on a bilateral basis. Be- in large hubs and market centers. Hubs are typi- cause marketers can pool contracts in one port- cally operated by one or several interstate pipe- folio, they are better able to absorb fluctuations line companies, which own the pipelines in supply or demand. interconnected at the hub. Hubs allow market The World Bank Group 7 participants to acquire natural gas from several gas prices occasionally become highly volatile. independent sources and ship it to several dif- A cold spell in February 1996, for example, ferent markets. This eliminates the need to con- caused extreme changes in spot prices at the tract natural gas and pipeline capacity all the way Henry Hub. The average spot price in Febru- from the wellhead to the consumption site. In- ary 1996 was US$4.41 per million British ther- stead, shippers can combine supply routes across mal units (Btu), a record high compared to the several hubs to diversify supply risks and mini- average annual price of about US$2 per mil- mize costs. Hub operators offer a wide variety of lion Btu. The spot price at Henry Hub peaked services—ranging from physical transportation of at more than US$15 on February 2, 1996, and natural gas to storage, processing, and trading— some industrial customers in Chicago paid a providing great flexibility for shippers and mar- city gate price of US$45 per Btu.3 keters in trading and delivering natural gas. Most players in the gas market dislike high vola- Hubs have become very popular among mar- tility in gas prices and seek ways to diminish keters and other players in the wholesale gas the price risk in the financial gas market. They market. More than fifty have been created are aided by a large number of intermediaries— across the United States since the first one, the gas marketers that compete fiercely to struc- Henry Hub, was established in May 1988 in ture the best ways of minimizing price risk for Erath, Louisiana. The Henry Hub, which is also customers. the largest hub in the United States, is a major natural gas interchange operated by Sabine Pipe The U.S. financial gas market had its begin- Line Company, a subsidiary of Texaco. At this nings in the late 1980s, when several financial hub marketers and traders have access to large institutions began to offer custom-tailored natu- consumer markets in the Midwest, Northeast, ral gas futures contracts. As noted, the first stan- and Southeast and along the Gulf Coast through dardized financial gas contract was introduced nine interstate and three intrastate interconnect- by NYMEX in April 1990, in the form of a natu- ing pipelines. The market participants trans- ral gas futures contract with delivery at the ported about 550 million cubic feet of gas a Henry Hub. In April 1992 NYMEX added a day through the Henry Hub in 1995. natural gas options contract for delivery at the same location. NYMEX and the Kansas City Almost all major hubs in the United States have Board of Trade have since introduced three developed into spot markets where natural gas more natural gas futures and options contracts, is traded continuously. The most important with three different delivery locations, to re- natural gas spot market is at the Henry Hub. flect regional differences in the market value This highly liquid and efficient spot market de- of natural gas. termines the market price of natural gas on a continuous basis. The Henry Hub spot price Financial gas trading has proved popular among plays a key role in the U.S. gas industry. Gas gas market participants. Between 1991 and 1995 industry participants use the spot prices to the volume of natural gas futures contracts traded evaluate their contract portfolios and make increased from 0.42 trillion cubic feet to 80 consumption or investment decisions. And the trillion—four times the physical consumption of Henry Hub is the pricing point for the first fi- natural gas in 1995. The turnover in futures trad- nancial gas contract, the New York Mercantile ing was US$125 billion in 1994, about 60 per- Exchange (NYMEX) natural gas futures contract. cent more than the turnover in physical gas that year. Most financial gas trading is conducted by Financial gas market marketers (which held 34 percent of the open interest on natural gas futures in the first quar- Participants in natural gas spot markets in the ter of 1996), producers (25 percent), and finan- United States face substantial price risks, as spot cial institutions (20 percent). 8 Development of Competitive Natural Gas Markets in the United States Electronic trading and market centers improvement of the regulatory framework for the gas industry. Such measures as liberalizing The introduction of electronic trading systems wholesale gas prices and the bulk supply of in the past two years has led to the develop- natural gas free market forces in segments where ment of market centers connected to multiple competition is both feasible and socially desir- hubs by electronic networks. Electronic trading able. Regulators also must focus on improving allows market participants to trade not only the regulation of pipeline transportation and natural gas, but also pipeline capacity and stor- minimizing its distortive effect on competitive age services at all interconnected hubs and pipe- gas markets. Introducing flexibility into pricing lines. It also facilitates communication between and other conditions of transportation pipeline companies, shippers, and hub opera- contracts—such as delivery locations or the bal- tors. Many electronic trading systems are linked ancing of gas shipments—and standardizing to other commercial networks that supply in- pipeline operations promote more efficient use formation and news relevant to the gas industry. of pipelines and benefit all industry participants. Electronic trading has its origins in the electronic The U.S. experience also shows the viability of bulletin boards established by interstate pipe- competition in the deregulated wholesale gas line companies in 1993 to support resale of pipe- market and the important role of gas market- line capacity. Standardization of these electronic ers and spot markets in increasing the efficiency bulletin boards simplified the trading of pipe- of gas transactions and prices. Liberalized Viewpoint is an open forum intended to line capacity and showed the advantages of elec- wholesale prices create many profit opportu- encourage dissemina- tronic trading. In late 1994 three commercial nities in the gas market, and these attract new tion of and debate on electronic trading systems were introduced that entrants to production, marketing, and supply. ideas, innovations, and best practices for ex- allowed market participants to trade natural gas Many of the new entrants bring new services panding the private and pipeline capacity electronically across sev- and products that increase the range and qual- sector. The views pub- eral markets and pipelines. By the end of 1996 ity of choices for gas industry participants. lished are those of the authors and should not almost all major pipeline companies in the be attributed to the United States had introduced electronic systems. Deregulation of the U.S. gas industry is far from World Bank or any of complete, however. Regulation of charges for its affiliated organiza- tions. Nor do any of the The largest electronic trading system in the United interstate pipeline transportation and capacity conclusions represent States today is Altra Streamline, which is linked release still limits the efficient allocation of trans- official policy of the to eight market centers and forty-five interstate portation contracts. But the most important task, World Bank or of its Executive Directors pipelines in the United States and Canada. The and the biggest challenge for regulators, remains or the countries they average daily volumes traded in this system the deregulation of retail gas markets in indi- represent. range from 10 million to 200 million cubic feet vidual states. These issues will continue to keep To order additional of natural gas. Many small systems are integrat- U.S. gas regulators busy. copies please call ing with larger ones to offer shippers and mar- 202-458-1111 or contact keters a wide variety of services across all major 1 Suzanne Smith, editor, This example draws on Richard J. Pierce Jr., “Reconstituting the Room F6P-188, gas markets in the United States. Electronic trad- Natural Gas Industry from Wellhead to Burnertip,” Energy Law The World Bank, ing systems have great potential in the world of 2 Journal 9 (January 1988): 1–57. 1818 H Street, NW, Pierce (1988) and U.S. Department of Energy, Energy Policy Act deregulated natural gas and power industries: Transportation Study: Interim Report on Natural Gas Flows and Rates Washington, D.C. 20433, or Internet address they can link marketers to all major regional (DOE/EIA-0602[95], Energy Information Administration, Washing- ssmith7@worldbank.org. gas and electricity markets in the United States. 3 ton, D.C., 1995). The series is also Energy Information Administration, Natural Gas 1996: Issues and available on-line Trends (DOE/EIA-0560{96], Washington D.C., 1996). (www.worldbank.org/ Conclusion html/fpd/notes/ Andrej Juris (andrej_juris@nera.com), NERA, notelist.html). The U.S. experience in gas industry deregula- Washington, D.C. Sponsored by the Private Printed on recycled tion shows that the development of competitive Participation in Infrastructure Thematic Group. paper. gas markets must be supported by continuing