NATURAL GAS: ECONOMICS,

1
NATURAL GAS ECONOMICS, STRUCTURE AND REGULATION
The National Regulatory Research Institute
Ken Costello, Senior Institute
Economist 49th Annual Regulatory Studies
Program Institute of Public Utilities Michigan
State University August 6, 2007
2
Topics

• Structure of the U.S. natural gas sector
• Important functions of a local gas distribution
  company (LDC)
• Federal regulation
• State regulation
• Current issues
• Historical statistics and EIA projections

3
Industry Segments

• Production (unregulated)
• Interstate transmission (regulated by FERC)
• Intrastate transmission (regulated by state PUCs)
• Gathering and processing (regulated by some
  states)
• Local distribution (regulated by state PUCs)
• Consumers (vary in size and how gas is used)

4
Structure of the U.S. Natural Gas Sector
5
Basic Technical and Economic Features of the U.S.
Natural Gas Industry

• Competitive production sector over 7,000
  producers, with 21 major companies (top 10
  companies produce about 45 percent of total U.S.
  production)
• Imports make up about 15 percent of our gas,
  mostly from Canada and increasingly from other
  countries in the form of liquefied natural gas
  (LNG)

6
Basic Features - continued

• Interstate pipelines carrying gas long distances
  from gas fields to market areas (about 90
  pipelines, with more than 250,000 miles of pipes)
• Market centers and hubs (over 40) facilitate
  trading of gas supply away from production
  areas/wellhead and toward pipeline
  interconnections, storage areas and major market
  areas

7
Basic Features - continued

• Storage facilities (mostly owned by pipelines and
  LDCs) serve important functions
• Reduce the magnitude of short-run market price
  fluctuations
• Help marketers, pipelines and LDCs to manage the
  price and availability of gas year-round
• More recently, marketers use storage as a
  financial tool, relying on price fluctuations in
  the spot and futures markets to create arbitrage
  opportunities

8
Basic Features - continued

• Storage facilities -- continued
• With storage, the market-clearing price is
  determined not only by current production and
  consumption, but also by the aggregate storage
  level
• Over 200 independent and affiliated marketers and
  brokers providing both wholesale and retail
  services
• Individual pipeline operation of facilities (no
  centralized control, like in some regional
  electricity markets)

9
Basic Features - continued

• LDCs provide both bundled sales service and
  transportation
• Scale economies for delivery services, which
  require some form of price regulation
• Open access to interstate pipelines (contract
  carriage)
• Open access to distribution systems for large
  customers and many small customers (customer
  choice programs)

10
Basic Features - continued

• Well-developed spot and futures markets (NYMEX
  futures market since 1990, options on futures
  contracts since 1992)
• Bypass of local distribution systems by some
  large customers (industrials, electric
  generators)
• Almost all large customers buy only
  transportation service from the local gas utility

11
Basic Features - continued

• Small customers in 19 states and the District of
  Columbia purchase gas from third parties, with
  only one exception (the Atlanta area) where the
  local utility is not the provider of last resort
  or the default supplier
• Industrials are the largest user of gas (about 40
  percent of total), but gas consumption for
  electric generation has grown most rapidly and
  will continue to do so

12
Basic Features - continued

• Primary markets for gas use (1) direct energy
  source (primarily heat), (2) feedstock
  (industrial), and (3) fuel for electric
  generation
• Pipeline and LDC marketing affiliates are
  important players

13
Sources of Gas Supplies for the U.S. Market

• Western Canada and Rockies
• Conventional
• Coal bed methane
• Tight gas sands
• Gas shales
• Gulf of Mexico
• Deep drilling on shelf
• Deep water
• East Coast
• Offshore

14
Sources of Gas Supplies for the U.S. Market -
continued

• Overseas - LNG
• Numerous sources around the world
• Northern Frontiers
• Mackenzie Delta
• Alaska North Slope
• Canadas High Arctic

15
Over 400 Storage Facilities in the U.S.
16
U.S. Interstate and Intrastate Natural Gas
Pipelines
17
Gas Market Centers
18
Status of Gas Choice Programs, as of December
2006 (source EIA)
19
Gas Choice Programs

• Background
• Currently, 19 states and D.C. have programs in
  place allowing for small-customer choice
• Over 55 of residential customers in the U.S. are
  eligible to choose their supplier
• As of December 2006, 4.2 million residential
  customers participated or about a 12
  participation rate (a decline from 20 for 2001
  but a slight rise from 2005)

• In some states, programs are inactive or have
  extremely low participation (California,
  Massachusetts, New Mexico and West Virginia)
• A few cases of pilot-program terminations
  namely, Delaware and Wisconsin
• Most publicized program --Atlanta Gas Light
  (AGL), which by itself has about 35 of the total
  residential participants in gas choice programs
  across the U.S.

20
Gas Choice Programs -- continued

• Background continued
• Evolving program changes in terms of size, scope,
  design, and implementation a learning process
  for gas utilities, marketers, and regulators
  (e.g., program expansions in Indiana during 2006)
• For various reasons, declining number of
  marketers serving residential customers over the
  past few years a 21 percent decrease in active
  marketers since 2002
• Since 2001, stagnant, or negative, growth in
  participation rates for several programs (e.g.,
  DC, Maryland, New Jersey, Pennsylvania)
• Highly uneven participation rates across programs
  

21
Participation Rates for Selected States with Gas
Choice Programs (2006 and 2002)
22
Local Gas Distribution Companies (LDCs)

• Own and operate city gate to burner tip
  distribution facilities (the city gate is the
  interconnection between the interstate pipeline
  system and the local distribution system)
• Network includes low pressure distribution lines,
  measurement and pressure regulators
• Major buyers of gas supply, interstate
  transportation and storage services
• Regulated by state public utility commissions

23
Major Activities of an LDC

• Long- and short-term planning
• Forecasts demand for gas
• Determines long-term/short-term needs for
  resources/assets/facilities (e.g., the design
  day)

24
LDC Activities - continued

• Gas acquisition/procurement/hedging portfolio
  strategy and tactics
• Producers
• Marketers and brokers
• Short-term contracts
• Long-term contracts (gt 1 year)
• Spot market (next day, next month)
• Local gas production
• Financial derivatives (e.g., futures contracts)
• Outsourcing

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A New Game For Gas Utilities Since the Early
1990s

• New responsibilities and risks with respect to
• Commodity gas procurement
• Interstate pipeline transportation
• Price-risk management
• More choices of services and providers
• More transparent price information
• Availability of different financial instruments
• Recent focus on achieving an optimal balance
  between minimum prices, reliable supply, and
  moderate price volatility

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Objectives of Gas Procurement Planning

• Reliable supplies delivered to the city gate
• Commodity and capacity costs compatible with
  market conditions
• Development of a portfolio to achieve
  reasonable costs to support reliability
• Balancing of reasonable costs and moderate
  price stability (and, relatedly, price
  predictability)

27
Portfolio Analysis Tradeoff between Risk and
Expected Cost
Reward (1/Expected Cost)
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Role of Storage

• Lowers price volatility
• Acts as a physical hedge
• Helps meet peak winter demand
• Can reduce overall gas costs by taking advantage
  of seasonal price differences
• Can be used to arbitrage market opportunities
  (i.e., to profit from changed market conditions)

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Contracting for Commodity Gas

• Fixed price or indexed (monthly, weekly)
• Duration of contract (daily, monthly, less than 1
  year, more than 1 year)
• Firmness of service
• Base, swing or peaking
• For example, swing contracts allow the buyer to
  vary its take, up to a Maximum Daily Quantity
  (MDQ)

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Contracting for Pipeline Services

• Firmness of service
• For example, under no-notice service, the
  delivery of natural gas occurs on as-needed
  basis, without the need to precisely specify the
  delivery quantity in advance
• FERCs SFV pricing regime makes firm
  transportation service expensive, relative to
  interruptible service

• Recent concern by some industry observers over
  the decline in long-term contracts
• Pros and cons of long-term contracting (see next
  table)
• Contracting in the context of todays gas market
• The load profile as a determinant of the mix of
  pipeline services

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Reasons for Long-Term Contracting in the
Economics Literature

• Assure reliability over time
• Avoid short-run demand or supply shocks, and
  related risk of curtailments
• Reduce the transaction costs associated with
  repeated spot-market purchases
• Reduce price risk when futures contracts or
  financial instruments are unavailable
• Protect against price increases resulting from
  the exercise of market power
• Increase certainty of revenues from investments

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Contracting for Long-Term Pipeline Services
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The Spot Or Cash Market

• Definition the market for a cash commodity where
  the actual physical product is traded
• Examples day-ahead, monthly gas transactions
• Low-transaction-cost auction market
• Prices determined by supply and demand but
  because of storage, at the market-determined spot
  price production is not equal to demand
• The spot price is determined by several factors
  (1) production cost, (2) storage levels, (3)
  economic conditions, (4) weather, (5) pipeline
  capacity, and (6) random shocks

34
The Spot Or Cash Market -- continued

• Inherently volatile and unpredictable prices
• Consequently, demand by market participants for
  alternative transaction and risk management
  mechanisms (e.g., bilateral contracting, storage,
  vertical integration, financial derivatives)
• Requirement of open access to the delivery
  network
• The spot price is used as a reference price in
  bilateral gas supply contracts

35
The Spot Or Cash Market -- continued

• Spot market as a prerequisite for a futures and
  options market and the trading of other financial
  instruments
• Effect of a well-functioning spot market on
  contracting
• Shorter-term contracts
• Indexing of the contract price to the spot price
• Termination of contracts on short notice

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Historical Series for the Henry Hub
Price,1993-2007
37
NYMEX Futures Prices, as of July 9, 2007
38
Illustrations of a Portfolio

• Utility X
• Purchase of fixed-price contracts for price
  stability
• Purchase of indexed contracts for the winter
  months
• Purchase of monthly and daily spot gas to
  displace more expensive swing transactions, fill
  summer load, and cover shortfalls

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Illustrations of a Portfolio -- continued

• Utility Y
• Storage meeting one-third of winter demand
• Physical contracts meeting another third
• Spot transactions meeting the last third
• Financial hedging covering a portion of spot
  purchases

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Illustrations of a Portfolio -- continued

• Utility Z
• Storage meeting 70 of the winter requirements
• Remainder met by long-term contracts indexed to
  regional spot prices
• No financial instruments
• No spot purchases

41
Noticeable Trends in Gas Procurement

• Application of the principles of portfolio theory
  to the procurement of gas supplies and
  transportation
• Price stability and predictability as an explicit
  objective

• Increased use of financial instruments for
  hedging
• Use of storage for additional functions (e.g.,
  parking, balancing, arbitrage opportunities)
• Shorter-term pipeline service transactions

42
Noticeable Trends in Gas Procurement - continued

• Movement away from multi-year commodity gas
  transactions
• Competitive bidding for gas procurement
• Submittal of annual gas supply plans for
  regulatory review, with the result of better
  documented information provided upfront to
  regulators

43
LDC Activities - continued

• Purchases capacity from pipelines
• Long-term firm contracts
• Short-term firm contracts
• Interruptible capacity
• Purchases/builds storage
• Market area storage
• Local storage

44
LDC Activities - continued

• Sells services
• Bundled gas/transportation service
• Transportation
• Other unbundled services (e.g., surplus pipeline
  capacity)

• Customer categories ( ) percent of total
  U.S. gas sales
• Residential (22 percent)
• Small commercial (14 percent)
• Large commercial and industrial (43 percent)
• Electric generators (18 percent)
• Transportation (3 percent)

45
Federal Regulation of Natural Gas

• The Federal Energy Regulatory Commission (FERC)
  mandate ensure adequate supply of natural gas
  at reasonable prices
• Regulates pipeline, storage, and liquefied
  natural gas facility construction
• Regulates natural gas transportation, including
  setting rates, in interstate commerce

46
Federal Regulation of Natural Gas - continued

• FERC mandate -- continued
• Issues certificates of public convenience and
  necessity for interstate pipelines and storage
  facilities
• Sets rates for interstate and wholesale storage
  services
• One current major concern of FERC is the
  possibility of inadequate infrastructure
  development, especially regarding LNG terminals
  and storage facilities and to a lesser extent
  pipelines

47
Guiding Principles of FERC Policies

• New gas supply sources and infrastructure
  development must be encouraged
• Regulation is a balancing act, with stakeholders
  including other government agencies, competitors
  of pipelines, shippers, landowners and pipelines

• Commodity and other competitive goods and
  services are best left unregulated
• Interstate gas pipelines have monopoly
  characteristics and must continue to be regulated
• Pipeline transportation must be operated without
  undue discrimination or preference

48
Ratemaking at FERC

• Cost of service method
• Discounted Cash Flow (DCF) analysis in
  determining the cost of equity
• Based on the notion that equity investors have
  two sources of return, dividend yield and growth
  in value
• Estimating growth is the difficult task subject
  to uncertainty

• Straight fixed variable rates (SFV)
• All fixed costs are recovered through a
  reservation charge (i.e., fixed rate based on
  peak-day demand)
• All variable costs are recovered through a usage
  charge (i.e., volumetric rate)
• Rationale (1) should maximize pipeline
  throughput over time, (2) allows gas to compete
  with alternative fuels on a timely basis

49
Major Federal Actions Over the Past 25 Years

• Natural Gas Policy Act of 1978
• FERC Order 380 (1984)
• FERC Order 436/500 (1985-87)
• Natural Gas Wellhead Decontrol Act of 1989
• FERC Order 636 (1992)
• FERC Order 637 (2000)

50
Major Federal Regulatory Changes (Source FERC
staff)
51
Pipeline Safety Regulation

• U.S. Department of Transportation (DOT) is
  responsible for enforcing regulations pertaining
  to pipeline safety
• Federal pipeline safety regulations have the
  objectives of
• Assuring safety in design, construction,
  inspection, testing, operation, and maintenance
  of pipeline facilities and in the siting,
  construction, operation, and maintenance of LNG
  facilities
• Setting out parameters for administering the
  pipeline safety program

52
Pipeline Safety Regulation continued

• Compliance with pipeline regulations through
  partnerships with state agencies
• States responsible for intrastate pipelines
  (assuming their safety programs are federally
  certified or states entered into an agreement
  with DOT)
• Federal government responsible for interstate
  pipelines
• The federal/state partnership helps to assure
  uniform implementation of the pipeline safety
  program nationwide
• States must enforce at least the federal
  regulations, with many states actually
  implementing more stringent regulations

53
Pipeline Safety Regulation - continued

• A state must provide for sanctions substantially
  the same as those authorized by the pipeline
  safety statutes
• Federal pipeline statutes provide for exclusive
  federal authority to regulate interstate
  pipelines DOT, however, may authorize a state to
  act as its agent to inspect interstate pipelines,
  but retains for itself responsibility for
  enforcement of the regulations

54
Major Functions of State PUCs

• Approves the cost of purchased gas (e.g., via
  PGAs)
• Approves construction of distribution facilities
  (e.g., distribution pipes, storage facilities)
• Issues certificates of convenience and necessity
• Assures high quality and safe service

55
State PUC Functions - continued

• Approves base rates for the sale of services
• Example Standard rate method (stylized model
  for setting Base Rates)
• R RR OC (r x RB)
• P x Q OC (r x RB)
• P OC (r x RB) Average Cost
• Q
• where, RR Revenue Requirement, R Revenues, OC
  Operating Costs, r Allowable Rate of Return, RB
  Rate Base, P Price, Q Sales

56
State PUC Functions - continued

• Standard ratemaking method 3-step approach
• Revenue requirement
• Recovery of capital investments (depreciated over
  their economic lives)
• Rate of return on investments
• Recovery of operating costs
• Cost allocation (how much revenues to collect
  from various customer groups and services)
• Rate design (how to collect revenues from various
  customer groups and services)

57
State PUC Functions - continued

• Other components of the ratemaking function
• Purchased gas adjustment clauses (PGAs)
• Financing of social initiatives
• Low-income assistance
• Demand-side management and energy conservation
  programs (or energy efficiency)
• Research and development

58
Evolution of State Regulation

• 1980s The decade of new state commission
  initiatives
• Heightening of state commission scrutiny of LDC
  operations, gas purchases and other costs
• Introduction of demand-side management (DSM) and
  energy conservation programs, and integrated
  resource planning (IRP)
• Initiation of service unbundling for large
  customers

59
Evolution of State Regulation - continued

• 1990s The decade of retail-access expansion and
  low gas prices
• Proliferation of service unbundling for large
  customers
• Introduction of pilot and permanent choice
  programs for small customers (including
  residential)
• Introduction of performance-based regulation
  (PBR) for gas procurement
• Rapid growth of new gas-fired generating plants

60
Current Natural Gas Issues

• High natural gas prices
• (What can PUCs and LDCs do, if anything? (see
  NARUCs Information Toolkit)
• Effect on different gas consumers
• LDC price-risk management (or hedging)
• Purchasing of futures contracts and other
  financial derivatives by utilities, in addition
  to traditional hedges such as storage and
  long-term contracts

61
Current Natural Gas Issues - continued

• LDC price-risk management (or hedging) --
  continued
• How much are consumers willing to pay for more
  price stability?
• How much should a utility spend on hedging, and
  how much should it hedge?
• Utility incentives to hedge
• Prudence criteria and regulatory pre-approval
  commitment
• An element of gas portfolio management

62
Current Natural Gas Issues - continued

• The need for new sources of gas supplies
• LNG
• Alaskan gas
• Opening up restricted areas in the Lower-48 for
  drilling and exploration?
• Gas-electricity interdependency
• Gas transportation constraints
• Incompatible timelines between the two industries
• Reliability consequences for electric power
  systems (e.g., security)
• High gas prices driving up electricity prices

63
Current Natural Gas Issues - continued

• Infrastructure development (LNG terminals,
  storage facilities, pipelines)
• Fuel diversity for electric generation
  particularly, shifting from gas-fired electricity
  generation to non-gas technologies, such as
  nuclear, renewable energy and clean coal
• Energy efficiency (the promotion of
  utility-funded energy conservation initiatives)

64
Current Natural Gas Issues - continued

• Retail ratemaking problems with existing rate
  designs, changed ratemaking objectives and their
  priorities, cost riders, conservation tariffs,
  straight fixed-variable rates, the impact of high
  gas prices on low-income households

65
Summary of Recent Market Developments in the
Natural Gas Sector

• Spot gas prices so far in 2007 ranged between
  6.00-8.00, which is generally higher than last
  years prices
• Right before this summer, forecasts called for
  lower spot prices in the short term because of
  (1) high storage levels, (2) record LNG imports,
  (3) a rise in domestic production, and (4) a
  rebound in imports of Canadian gas
• But prices rose in early July because of hot
  weather driving up the demand for gas by power
  generators

66
Summary of Market Developments-- continued

• Much drilling activity and well completions, but
  the productivity of gas wells has fallen sharply
  over the past several years (the number of
  gas-directed rigs 8 higher than last year)
• As of the end of June, storage levels were about
  17 above the five-year average for that time of
  year but below last years level (strong
  incentive for storage last year because of the
  wide spread between prevailing spot prices and
  the winter strip price, e.g., NYMEX futures
  price)

67
Summary of Market Developments-- continued

• Domestic gas production expected to increase
  incrementally over the next few years, mostly
  from unconventional sources (e.g., coalbed
  methane)
• Industry experts concur on the need for LNG to
  help fill the supply gap until the end of the
  decade and beyond to meet future demand needs
• Growing gas supplies in the future from LNG
  imports and unconventional domestic production
  (coalbed methane, tight sandstones and gas shales)

68
Summary of Market Developments-- continued

• Natural gas prices in the short term are
  extremely sensitive to various factors, making
  price projections highly vulnerable to error
  (even by highly paid hedge fund managers)
• Storage levels
• Weather
• Gas production
• Oil prices
• General economic conditions
• Regional pipeline capacity (e.g., bottleneck
  event)
• Fuel switching

69
Summary of Market Developments -- continued

• Experts disagree on longer-term natural gas
  prices specifically, over when and how much
  prices will start to deviate from the levels of
  the past few years
• Since the mid-1990s, domestic gas production has
  bumped up close to gas productive capacity (an
  omen of tough days ahead)

70
Summary of Market Developments-- continued

• Short-to mid-term supply/demand options to
  alleviate the tight gas-supply situation
• Expansion of existing LNG facilities and the
  addition of new facilities
• Increase in the capacity of dual-fuel electric
  generating units
• More aggressive energy-efficiency initiatives
• Increase in gas production from deeper waters in
  the Gulf and from the Rocky Mountains area

71
Summary of Market Developments-- continued

• Overall, the outlook for the gas market over the
  next few years is difficult to predict, as
  several factors will influence price and market
  conditions
• Current conditions in the gas market resemble the
  oil market during the 1970s

72

• Graphs, Statistics, and Supplemental Information

73
EIAs Short-Term Projections, as of July 2007

• Average wellhead price 6.89 per Mcf in 2007,
  and 7.50 in 2008 (the 2006 price was 6.41)
• Consumer prices residential prices projected to
  be about 3 lower in 2007 than in 2006 and then
  increase by 6.8 in 2008
• Consumption demand projected to increase by 4.3
  in 2007 and by 1.1 in 2008
• Supply moderate growth in 2007
• Above-average storage levels in 2007
• Domestic production slightly up in 2007
• Significant increase in LNG imports in 2007 and
  2008

74
EIAs 2006 and 2007 Projections(as of July 2006)
75
Wellhead Natural Gas Prices, 1980-2006
76
U.S. Natural Gas Wellhead Price, 1970-2030 (2005
dollars per thousand cubic feet)
History
Projections
Annual Energy Outlook 2006 and 2007
77
Composition of Natural Gas Prices Paid by
Residential Consumers During   the Heating
Season (Source EIA)
78
Total Natural Gas Expenditures, 1997-2006 (in
billions of nominal dollars)
For residential, commercial, industrial and
electric power customers
79
Declining Gas Consumption per Household since
1980 (Source AGA)
80
Declining Ratio of Natural Gas Consumption to
Economic Activity, 1980-2006
81
Natural Gas Expenditures by Income Category, 2001
82
Energy Costs by Income, 2004 (sourceBLS)
Annual spending on gasoline, motor oil, natural
gas, electricity, fuel oil and other fuels
83
Energy Consumption by Fuel, 1980-2030
quadrillion Btu
Projections
History
Petroleum
Coal
Natural Gas
Nuclear
Nonhydro renewables
Hydropower
EIA, Annual Energy Outlook 2007
84
Natural Gas Consumption by Sector, 1990-2030
Tcf
Projections
History
Industrial
Electric Power
6
Residential
Commercial
Transportation
EIA, Annual Energy Outlook 2007
85
Net U.S. Imports of Natural Gas by Source,
1990-2030
Tcf
Projections
History
Overseas LNG
Canada
Mexico
EIA, Annual Energy Outlook 2007
86
EIA, Annual Energy Outlook 2006
87
Additions to Electricity Generation Capacity in
the Electric Power Sector, 1990-2030
gWhs of net summer capacity
EIA, Annual Energy Outlook 2007