The Natural Gas Price Puzzle

Natural gas is back in the headlines, but unlike six years ago, price—not supply—is the issue.

Then, schools were out, factories were on short hours, and shopping malls were closing early because there was not enough gas to go around. Now gas supplies are adequate, but average prices to residential consumers have risen more than 50 percent in real terms since 1978, with about half of that increase coming since last winter. Further increases are in prospect.

Why have natural gas prices gone up so much, while oil prices recently have even declined? Why are prices rising now with supplies so abundant that some gas is going unsold? How much higher will prices go? What factors form the backdrop of the natural gas battles that now seem inevitable in Congress and, looking ahead, in the 1984 campaigns?

Origins of the problem

Today's natural gas price story begins with the Supreme Court's 1954 Phillips decision that imposed Federal Power Commission—now Federal Energy Regulatory Commission—price controls on the wellhead price of most gas flowing in interstate commerce. (Sales for use within producing states were not regulated under the decision.)

While a system to control wellhead prices took almost a decade to work out and had little direct effect until the mid-1960s, by the late 1960s underpriced gas was being consumed more rapidly than it was being found. More seriously, the low price was signaling consumers to install more long-lived gas-using equipment than could be served by the amount of gas that could be produced at those prices. The ultimate result was the system of curtailments and restricted access to gas that gave some users (including those in producing states) all they wanted at a submarket price, while forcing others to pay very high prices for alternative energy sources—oil or electricity—or do without energy.

The waste, inefficiency and, above all, the unfairness of a system that left gas prices too low led to demands for congressional action. The gap between existing and free market prices had to be closed. But if this were done quickly, the price increase could mean a shock to the economy, significant harm to some consumers, and windfall gains for some producers.

A legislative fix

After a marathon effort that left all parties exhausted (and many embittered), the Natural Gas Policy Act of 1978 (NGPA) was passed. It met some of the goals of its drafters: prices were started on an upward track toward free market levels; gas was shifted from consumers in producing states to others to relieve critical shortages, at least for the near term; the early burden of rising prices was placed disproportionately on industrial rather than residential or commercial consumers; and price increases were concentrated on potential gas sources where the supply effect was expected to be greatest. Today, however, consumers see most clearly another outcome of the NGPA—the rapid and, for some, devastating increase in their gas bills.

As it turned out, NGPA pricing provisions offered more latitude for increases in the average price of gas than its framers expected; thus, the gap existing in 1978 started closing quickly. Moreover, the price level at which competition from other fuels would take over the constraining role from regulation jumped as oil prices doubled less than a year after the NGPA was enacted. Competition for supplies, fueled by past, present, and expected shortages, pressed prices of controlled gas against regulated ceilings and allowed producers to obtain three or four times as much for the small quantities not subject to controls.

True, the decline in oil prices in real terms over the past year—by about 11.8 percent for heavy fuel oil and 9.3 percent for home heating oil—now has left natural gas prices with less catching up to do. But until the gap is fully closed—with falling oil or rising gas prices—further increases in the average wellhead price will be in store. Still, the 15 percent or so annual increases of the past few years may soon be over. Evidence suggests that, on the basis of supply and demand fundamentals, prices will stabilize this year or next—barring further disruptions in oil markets.

Price hikes and the "glut"

But for now, consumers are seeing big jumps in gas rates—with more to come—at the same time that some producers are complaining that they cannot find markets for some of the gas they want to sell. How can this be? Part of the explanation rests on the lags of price increases between the wellhead and ultimate consumers, and part on special circumstances, mentioned below. But fundamental factors also are operating at both the producing and the downstream levels.

Wellhead prices

To begin, it is not clear that field market prices are above the level that in the long-run would balance supply and demand. A glut exists, but it may be a surplus of short-run deliverability—ability to produce gas from already existing wells—and not of gas supply in a more basic sense. There are several reasons to believe this may be the case.

First, demand is depressed by the recession; with recovery, use will rise, and possibly by more than enough to offset further conservation in response to price increases that already have occurred.

Second, the rapid increase in price led to a spurt of drilling in established production areas. This increased short-term production, but did not yield commensurate reserves to support production over the longer term.

Third, until the glut appeared in full force, pipelines bid against one another for reserves by promising producers they would take gas at near-capacity output levels, whether there turned out to be a need for it at the burner tip or not. They could not offer what the gas was worth because of price controls, but through high "take-or-pay" contracts they could entice producers to sell by giving them revenue security and an earlier payout. With producers guaranteed sales (or at least revenues), pipelines lost flexibility to lower purchases when recession, tougher competition from oil, and conservation shrunk anticipated markets. Higher minimum takes thus led to a once-and-for-all spurt in gas available to end users.

Finally, the glut at current average prices is partly an artifact of wellhead regulations. Much gas is controlled at prices well below those required to induce replacement of the reserves being depleted, but it will continue to be produced until reserves are gone. Part of the resulting "cushion" between the price regulated gas could command in the market and what pipelines must pay for it is absorbed in very high prices for "deep" gas (from below the 15,000-foot level) that is not controlled under the NGPA. More of the cushion goes to pay for gas imported from Canada and Mexico at about twice the domestic price, and for a small quantity of even more expensive gas imported in liquefied form from Algeria. But this still leaves, for a while at least, more gas flowing than would be the case if the current average price were paid for all gas.

Surpluses in deliverability thus exist even though the average field price may still be too low to balance supply and demand once transitory phenomena pass. But why have prices not fallen temporarily to reflect this temporary condition? The answer can be understood on two levels, based either on the way regulations and private contracts work or on the economic fundamentals involved.

As for the first, long-term contracts between pipelines and producers—common in this industry—typically prevent adjustment of prices downward to meet fluctuations in demand. In the short run, when demand falls, the only recourse of pipelines is not to purchase more gas. The result, paradoxically, is to leave the price of gas going into the pipeline at the same high level and to leave some producers with gas they cannot sell—even at a lower price.

With respect to underlying economic factors, long-lived investments characterize every phase of the industry—from expenditures to find gas reserves that will be produced over a decade or more to similarly long-lived delivery systems and gas-using equipment. The economy as a whole—and that ultimately means consumers—cannot escape the cost of sustaining capacity through the ups and downs of demand due to the business cycle or to outside shocks such as those from fluctuating oil prices. The question is whether consumers will pay for the capacity required by paying more when demand is high and less when it is low, or instead, as is the case now, have stable prices with transitory gluts followed by supply stringencies. Long-term, fixed-price contracts served the economy reasonably well in the tightly regulated pre-NGPA era. But shorter terms and price flexibility may now be more in keeping, and indeed this is the direction the industry has been moving for the past year or so. (Extraordinary prices for deep gas are being negotiated downward, for example.) This is not a costless change, however, and it is creating strains up and down the line.

Transportation and delivery costs

The "rising prices in a glut" story does not end with the conditions surrounding the bargains struck between pipelines and producers. Consumers also must pay for transporting and delivering gas. While these costs are getting smaller relative to rising gas prices at the wellhead, they also have risen. The contributions of various causes to the increase vary system by system. In addition to general inflation, they include increased interest costs, higher costs for the gas they use themselves, larger charges for "uncollectables" (due to the recession and to the higher fuel prices some consumers have not been able to pay), and higher unit costs because fixed costs must be spread over fewer units actually sold.

This last phenomenon is important. It also is exceedingly frustrating to residential and commercial consumers who are trying to conserve to cut down on fuel bills. Such consumers have lowered their use, yet many costs of serving each one—metering, billing, maintaining a delivery system—remain the same. On a national basis, compared to 1978, 5.8 percent more consumers used 8.8 percent less gas in 1981; the 1982 conservation results will be even more striking. Given the large element of fixed costs, it is no surprise that distribution company rates were driven up. The same forces are at work pushing up pipeline transportation charges.

This rather straightforward supply, demand, and cost explanation of the price picture, accurate enough on a national basis, is vastly more complicated when specific producers, pipelines, distributors, and consumers are considered. The average cost of gas as it enters a particular pipeline, for example, depends on historical accident, location, timing, and bargaining power. Management decisions turn out well in some cases and poorly in others, and sometimes may favor pipeline interests even when that means higher prices down the line. As to individual consumers, their rates may depend on who serves them, which other customers share their system, and the goals and skills of state regulators who monitor distributor costs and rate structures.

The legislative agenda

While rectifying the underpricing of gas and distortions in its production and use have beneficial effects for the economy as a whole, the transition costs are large. What, if anything, can be done to reduce these costs and to share them more fairly?

Price increases have placed near-intolerable pressures on the poor in cold climates who rely on gas for heat. Higher bills have not been covered by additional welfare payments and have come too swiftly for the near-poor to adjust their budgets. Local relief agencies are swamped and some distribution companies are sinking under uncollectable bills of consumers that the law and humane concern demand they continue to serve. State utility commissions are helpless, though they bear the burden of public antipathy. Only added state and federal funds can help. The solution is clear, but it is difficult to implement in an era of shrinking budgets.

Dissatisfaction with sometimes idiosyncratic outcomes, with price disparities that are inequitable and inefficient, and with the prospects for further problems as, under the NGPA, more gas is decontrolled at the end of 1984, have sparked demands that federal regulations be changed. Contradictory themes are emphasized, however, and greatly different prescriptions are offered.

As suggested above, underlying factors constrain what gas legislation can accomplish. The poor can be protected only at extraordinary cost because submarket prices cannot be sustained in the long run without shortages. Gas demand fluctuates and the cost of sometimes idle capacity must be borne to make service available when times are better. Legislation can shift costs among parties, by altering contract terms and limiting take requirements, for example, but laws cannot make costs go away.

The transition toward more efficient use of natural gas and other resources that began with the NGPA has yet to run its course. Problems remain and strains continue that deserve careful and thoughtful consideration.

Because of the importance of natural gas and the strong emotions that it arouses, the coming debate is likely to be great political theater. As an antidote to bemusement, the wise spectator will keep in focus the economic forces that ultimately determine the limits of what can be accomplished.