The natural gas industry consists of exploration and production (E&P) companies and pipeline companies acting as somewhat separate industries. The Federal Power Act of 1935 created the Federal Power Commission (FPC). The Natural Gas Act of 1938 directed the FPC to regulate natural gas pipelines, but not wellhead prices. Like all federal regulations, jurisdiction was limited to pipelines in interstate commerce. Intrastate pipelines were beyond the reach of FPC price regulation. Demand for natural gas during the 1940s and 1950s exceeded the rate of pipeline expansion, resulting in price volatility and supply shortages in parts of the country. This led natural gas producers to request price caps on pipeline transportation for gas producers. The FPC did not believe that the Natural Gas Act gave it that authority.
In 1954, the Supreme Court determined that regulation of consumer prices required control over both producer prices and transportation in the landmark Phillips decision. Although price volatility was reduced by the Phillips decision, regulated price caps on production and pipelines eventually resulted in a two-tiered market; a price regulated interstate market and a largely market-based intrastate one. Producer states had ample gas supplies and transportation whereas user states had neither, resulting in the supply constraints of the 1970s. The solution came in the form of the Natural Gas Policy Act of 1978.
The Department of Energy Organization Act of 1977 created the Federal Energy Regulatory Commission (out of the old Federal Power Commission). The Natural Gas Policy Act of 1978 directed FERC to “reform” natural gas pricing. This essentially reversed the Phillips decision by deregulating wellhead gas prices. Gas production soared in the face of pent-up demand, depressing consumption. Consequently, the 1980s witnessed a significant oversupply of natural gas, a so-called bubble. Despite deregulation, competitive gas markets failed to develop, primarily due to continuing problems with pipeline regulation. At the time, pipeline companies controlled access to markets by both producers and consumers because pipeline companies purchased the gas they transported from producers and resold it to consumers.
Obviously, the price to consumers is dictated by the price paid to producers. Non-competitive selection of producers led to higher-than-necessary consumer prices. In addition, pipeline companies provide a variety of other services ancillary to gas transportation, including storage, balancing (evening out day-today demand variations to match monthly contract demand), and so on. Typically, pipeline companies bundled these services into the cost of transportation. In order to cut the Gordian knot presented by pipeline companies’ control over end-user prices, the FERC issued a series of orders aimed at introducing competition into the pipeline business while retaining regulatory control over the transportation function.
The first of these, Orders 436 and 500, were issued in the late 1980s. These orders allowed consumers to negotiate prices directly with producers and required pipelines to transport the gas resulting from these negotiations. These rules maintained the traditional role of pipeline owners as marketers (buyers and sellers) of natural gas, but allowed gas producers to secure access to pipelines for their own use. This allowed producers to balance supplies across production regions. In other words, if a producer had insufficient volume in one area but plentiful supplies in another it could arrange to transport the surplus to the region with excess demand. In these orders FERC established the concept of open access, or the use of a gas transportation system that one party owned by other parties on an equal access basis. Because pipelines would be transporting gas from unknown producers in unknown quantities, FERC established procedures for nominating sources of gas supply and allocating the gas being transported to specific shares of pipeline capacity. Differences between contract gas shipments and actual consumption left pipelines to make up the difference. Accordingly, FERC made balancing a competitive service. These orders stimulated innovation in pipeline tariffs to reflect variations in reliability (firmness) and transportation contract duration.
Reacting to industry innovation, FERC requested comments from consumers and industry about new ways of structuring gas transportation in what it called a Mega-Notice of Proposed Rulemaking, or Mega-NOPR, in July 1991. The Mega-NOPR marked the beginning of the end of gas price regulation. FERC Order 636, issued April 9, 1992, “restructured” (in FERC’s words) the natural gas industry to stimulate competition by consumers for gas supplies and transportation. Order 636 required pipeline companies to open access to capacity to any and all transporters and to unbundle transportation services so as to allow customers to select supply and transportation services from any competitor in whatever quantity and combination they desired. Order 636 had a revolutionary impact on the natural gas industry and wholesale gas market. It unleashed unprecedented exploration, pipeline construction, and marketing activities. Gas prices fell dramatically, while profits increased from increased sales. Electricity producers became a new market.
Financial markets quickly developed commodity products that paralleled the evolution of physical natural gas markets, including supply products tied to one or more of the 40 or so natural gas trading hubs that allowed buyers and speculators to hedge price and transportation costs irrespective of their actual location. In other words, consumers could negotiate the best terms for supply and transportation to their site and simultaneously negotiate better terms in other markets as a price hedge. The natural gas commodity market is now the most active commodity market on the New York Mercantile Exchange.
Order 636 also established a precedent for FERC to follow in electricity markets and provided lessons that were invaluable as FERC turned its attention to the electricity market, which it did next.
In 1954, the Supreme Court determined that regulation of consumer prices required control over both producer prices and transportation in the landmark Phillips decision. Although price volatility was reduced by the Phillips decision, regulated price caps on production and pipelines eventually resulted in a two-tiered market; a price regulated interstate market and a largely market-based intrastate one. Producer states had ample gas supplies and transportation whereas user states had neither, resulting in the supply constraints of the 1970s. The solution came in the form of the Natural Gas Policy Act of 1978.
The Department of Energy Organization Act of 1977 created the Federal Energy Regulatory Commission (out of the old Federal Power Commission). The Natural Gas Policy Act of 1978 directed FERC to “reform” natural gas pricing. This essentially reversed the Phillips decision by deregulating wellhead gas prices. Gas production soared in the face of pent-up demand, depressing consumption. Consequently, the 1980s witnessed a significant oversupply of natural gas, a so-called bubble. Despite deregulation, competitive gas markets failed to develop, primarily due to continuing problems with pipeline regulation. At the time, pipeline companies controlled access to markets by both producers and consumers because pipeline companies purchased the gas they transported from producers and resold it to consumers.
Obviously, the price to consumers is dictated by the price paid to producers. Non-competitive selection of producers led to higher-than-necessary consumer prices. In addition, pipeline companies provide a variety of other services ancillary to gas transportation, including storage, balancing (evening out day-today demand variations to match monthly contract demand), and so on. Typically, pipeline companies bundled these services into the cost of transportation. In order to cut the Gordian knot presented by pipeline companies’ control over end-user prices, the FERC issued a series of orders aimed at introducing competition into the pipeline business while retaining regulatory control over the transportation function.
The first of these, Orders 436 and 500, were issued in the late 1980s. These orders allowed consumers to negotiate prices directly with producers and required pipelines to transport the gas resulting from these negotiations. These rules maintained the traditional role of pipeline owners as marketers (buyers and sellers) of natural gas, but allowed gas producers to secure access to pipelines for their own use. This allowed producers to balance supplies across production regions. In other words, if a producer had insufficient volume in one area but plentiful supplies in another it could arrange to transport the surplus to the region with excess demand. In these orders FERC established the concept of open access, or the use of a gas transportation system that one party owned by other parties on an equal access basis. Because pipelines would be transporting gas from unknown producers in unknown quantities, FERC established procedures for nominating sources of gas supply and allocating the gas being transported to specific shares of pipeline capacity. Differences between contract gas shipments and actual consumption left pipelines to make up the difference. Accordingly, FERC made balancing a competitive service. These orders stimulated innovation in pipeline tariffs to reflect variations in reliability (firmness) and transportation contract duration.
Reacting to industry innovation, FERC requested comments from consumers and industry about new ways of structuring gas transportation in what it called a Mega-Notice of Proposed Rulemaking, or Mega-NOPR, in July 1991. The Mega-NOPR marked the beginning of the end of gas price regulation. FERC Order 636, issued April 9, 1992, “restructured” (in FERC’s words) the natural gas industry to stimulate competition by consumers for gas supplies and transportation. Order 636 required pipeline companies to open access to capacity to any and all transporters and to unbundle transportation services so as to allow customers to select supply and transportation services from any competitor in whatever quantity and combination they desired. Order 636 had a revolutionary impact on the natural gas industry and wholesale gas market. It unleashed unprecedented exploration, pipeline construction, and marketing activities. Gas prices fell dramatically, while profits increased from increased sales. Electricity producers became a new market.
Financial markets quickly developed commodity products that paralleled the evolution of physical natural gas markets, including supply products tied to one or more of the 40 or so natural gas trading hubs that allowed buyers and speculators to hedge price and transportation costs irrespective of their actual location. In other words, consumers could negotiate the best terms for supply and transportation to their site and simultaneously negotiate better terms in other markets as a price hedge. The natural gas commodity market is now the most active commodity market on the New York Mercantile Exchange.
Order 636 also established a precedent for FERC to follow in electricity markets and provided lessons that were invaluable as FERC turned its attention to the electricity market, which it did next.
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